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21. August 2019Investing in ETFs: Portfolio Construction and Due Diligence (4:57)
James Kim, Director of Capital Markets, discuss the creation and redemption mechanism of ETFs, key considerations for ETF portfolio construction and how an ETF sponsor’s capital markets desk can serve as a resource for investors conducting pre-trade due diligence.

Understanding ETF Creation and Redemption

So, like stocks, ETFs trade on exchange every day that the exchange is open. And similar to stocks, one can use any broker's platform to purchase or even sell ETF shares on exchange. However, one key difference between ETFs and stocks is that an ETF derives its value from an underlying portfolio of securities. And as a result, we sometimes see the price on the secondary market of an ETF diverge from the value of its underlying securities. When we see the secondary market price trade above the net asset value of an ETF, we call that a premium, and vice versa, in the event that the secondary market price trades or falls below the net asset value of the portfolio. Whenever that phenomenon happens, ETFs have a mechanism that we refer to as the primary market to relieve some of that pressure built up, whether it be in the form of a premium or a discount.

In the event that an ETF begins to trade at a premium, we'll see market makers and APs [authorized participants] step in to create shares, effectively increasing the supply of ETFs, bringing down the secondary market price to be more in line with the net asset value. The exact opposite would happen in the event that the fund was trading at a discount relative to its net asset value. We'd see market makers and authorized participants come in and redeem shares, effectively decreasing supply. And it's really that mechanism that's relied upon in order to keep the ETF's secondary market price in line with its net asset value.

Liquidity Considerations When Constructing an ETF Portfolio

When constructing a portfolio of ETFs, the ADV, or Average Daily Volume of an ETF, is definitely a factor that should be considered. With that said, I don't think one should rely solely on that to either make a decision or decide against an ETF. And the reason for that is, from our experience, ADV doesn't paint the entire picture of a fund's liquidity profile. Think of liquidity of an ETF in really two components. It's the liquidity in the secondary market, which the average daily volume is a good indicator of. But I think more importantly, in the case of a lot of more nascent or newer ETFs, the liquidity of the underlying is where market makers are going to derive the majority of the liquidity from.

The Role of an ETF Sponsor’s Capital Markets Desk

From an investor's perspective, there are a vast amount of resources available from a pre-trade standpoint. Investors can reach out to market makers or liquidity providers themselves. They can do the due diligence themselves, reach out to their custodian, or finally reach out to the sponsor's capital markets desk. So, most capital markets desks at sponsors are not trading desks. They're there exclusively for the best experience of the client. From my seat, I want to ensure that, at the end of the day, the client has the best experience coming into our products and out of our products. We have no skin in the game except for achieving best EX [execution] as it relates to our fiduciary duty for our clients. With that said, I think another value-add of capital markets desks as sponsors is the fact that these desks are really experts in their line of products, just given the proliferation of ETFs, and the various nuances associated with, for example, creating or redeeming into those products. It's typical for custodians, liquidity providers to keep track of all those minute details.