SPECIAL REPORT: A new phase begins in ETF growth

Baker says ETFs resolve a number of issues related to both unlisted managed fund and LIC structures. He says they are far more accessible and far more flexible in certain ways, and they overcome the premium/discount issue of LICs.

One of the big questions often raised about ETFs is why they trade so consistently at NAV, Baker says.

“You’d be amazed – we get very long-experienced people at very senior levels in the industry who do not understand why these things trade at NAV,” he says.

“It’s because the way money moves in and out of these is very different [to managed funds and LICs].

“There’s two ways of buying an ETF unit. If you’re a small investor, you log in to your CommSec account and you buy and trade it like any other stock. Exactly like a BHP share. You look on the screen, there’s buyers and sellers stacked up on either side, you put in your order and off you go.

“If, however, you’re an institution, with a big order, you don’t do it that way. Say you want to buy $100 million worth of an ASX 50 ETF, for example, you’ll call up your broker, and they will call up a market maker, who is an authorised participant, and say they want to buy $100 million. And what they doasafirststepisgooutintothe market and buy $100 million of the stocks that make up the ASX 50, in those exact proportions. It sounds complicated, but for big instos it’s a no-brainer; they do it in two seconds.

“So as a first step they’ve got $100 million of all the stocks in the ASX 50. Then they go to the ETF and say, OK, I want $100 million of the units; here’s $100 million of your portfolio. So it’s like an in specie transfer at that point. “And that’s how new units are created. It’s completely different from your unlisted managed fund, where you write out a cheque, it goes in at the end of the day, at that day’s price, it gets processed in a few days, money kind of leaks into the trust and the manager decides whether to invest it or not.

“Investors and advisers need to think about two levels of liquidity with ETFs”

“That’s kind of critical, because that ultimately explains why these things [ETFs] trade at NAV, because exactly the same works in reverse. If I want to get out of this thing – I want to sell my $100 million – I can present those units, and I can obtain $100 million worth of stock, at NTA. The critical thing is you have direct access to the NTA, to the assets.

“As soon as a price starts to deviate on the market from the NTA, there’s an arbitrage opportunity. If it starts to drift away, the professional market makers can go in and buy up all those units, present it to the ETF, and get the underlying stock at NTA. That’s why it works.

“As simple as the concept is, you’ve got direct access to the assets of the ETF. As long as you’ve got that, this thing has to trade around NTA.”

Robyn Laidlaw, ETF product manager for Vanguard, says the job of a market maker is “exactly what the name says: to make a market and to provide liquidity”. Liquidity is a very important element in enabling ETFs to trade closely to NTA, and in keeping the bid/offer spread as narrow as possible. “Investors and advisers need to think about two levels of liquidity with ETFs,” Laidlaw says.

“There’s a level of liquidity in relation to the volume that’s being traded, but in an ETF the real level of liquidity is the liquidity of the fund in which you’re investing.

“The authorised participants are in the market, competing on price. So that provides some competitive tension in the marketplace around how it’s priced. If the market price moves out of line with the NAV, those authorised participants can go in and create new units.”

Laidlaw says the liquidity of the ETF itself is related to the index it tracks. The more liquid the securities that make up the index, the easier it is for the market maker to do its job.