What is an ETF?

Mechanism

Update : Oct. 29, 2012

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What is the mechanism of ETFs?

1. Mechanism

ETFs are viewed in the US as regular index-tracking investment trusts. However, because many investors in Japan remain unacquainted with these products, the following is a simple explanation of the mechanism behind them.
For ETFs, management companies which create the product conduct an offering and issue ETF beneficiary certificates to investors who respond to such offering. This applies to both the initial offering conducting when establishing the investment trust and the continuous offering thereafter. The difference with regular investments trusts is that the investors responding to such offerings are primarily “portfolio managers (such as pension funds)” and “the securities company acting as a designated participant”. This is because general investors responding to the offering of a regular investment trust are contributing cash in exchange for beneficiary certificates, whereas in the case of ETFs, beneficiary certificates are only received when baskets of stocks which cause the ETF to track an indicator are contributed. (However, in the case of a cash-contribution ETF, such as an investment trust tracking the Nikkei 300 stock price index, beneficiary certificates are exchanged for contributions of cash.) This is called “ETF creation”.

Accordingly, because general investors are unable to participate in these offerings, they must instead purchase small lots of beneficiary certificates offered by participants in the offering through the TSE ETF market. Also, the portfolio manager that participated in the offering holds beneficiary certificates as a type of passive management for sale in the market in cases where conversion to cash is required. Furthermore, the securities company acting as a designated participant conducts arbitrage trading with equities and index futures using the ETF beneficiary certificates it holds.

The clear separation between investors which acquired large amounts of beneficiary certificates through the offering and general investors who acquire small lots of beneficiary certificates through the market is another feature of ETFs. Also, by employing this method, ETFs do not need to purchase stocks after gathering small amounts of funds like a regular investment trust, thus lowering management costs and reducing tracking errors.

Furthermore, ETF beneficiary certificates are exchangeable for stock baskets which include trust assets. In such case, through a mechanism which is the completely opposite of the offering (creation), a portfolio manager or designated participant securities company which holds an equivalent amount of beneficiary certificates brings a specified amount of those to the management company and exchanges them for stock. This is called “ETF exchange”. (The designated participant securities company serves an important role in the ETF mechanism. During both offering (creation) and exchange, entrustment of stock baskets and issue of beneficiary certificates is always conducted through the designated participant. The designated participant is designated by the management company and the participant’s name is included in the Securities Registration Statement, etc. as an entity which handles offering.)

Also, it is important to note that foreign ETFs differ from domestic ETFs in that there are some cases where creation and exchange cannot be conducted in Japan.

2. What are the two ETF markets?

The ETF market is made up of the secondary market and the issuance market.

(1) Secondary Market

The secondary market for ETFs is a market in which ETF beneficiary certificates are freely traded in small lots between an unspecified number of investors. The market’s liquidity is publicly released in the form of the daily trading volume.

(2) Issuance Market

In the secondary market for ETFs, there may be cases where sufficient liquidity cannot be supplied for the large order trading demands of institutional investors conducting transactions on the scale of billions of yen.
It is in the other ETF market, the issuance market, that such investors can conduct creation/exchange of large lots of beneficiary certificates and execute trades which exceed the scale of the secondary market’s trading volume.

In this way, it can be said that ETF liquidity requires support from not only the daily trading volume on the secondary market, but also the large transactions from creation/exchange in the issuance market.
(*Actual figures regarding ETF creation/exchange can be found in Securities Registration Statements, etc.)

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