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From index to fund

Mutual funds: Simple, but expensive

Transforming an index into a mutual fund is a fairly straightforward process. An investor gives the mutual fund company cash, which it uses to purchase securities in the underlying index in their respective weights and, in turn, issue new shares of the fund to the investor. Conversely, when an investor wants to sell their shares, those shares are returned to the fund company, in exchange for cash.

It’s a simple system, but this simplicity doesn’t always come cheap. By buying and selling the underlying securities, the fund company also incurs trading spreads and commissions—costs which it passes along to its investors. Whenever new investors enter a fund, the fund’s existing investors are forced to eat the cost. When investors leave a fund, it’s even worse for those left behind. In selling securities to redeem the exiting investor’s shares, the fund company often realizes capital gains and possibly incurs a taxable event—a burden once again shouldered by those left behind.

What’s more, all mutual funds must pay out any dividends and cap gains accrued every year. So even if the fund lost value, there’s still a tax liability that may be involved.

ETFs: The creation/redemption mechanism

ETFs work differently. An index becomes an ETF via a process known as creation/redemption.

Say a prospective ETF provider (that is, a sponsor) wishes to create a new product. They first file a plan with the SEC to create a new fund; when the plan is approved, the sponsor enlists the help of an authorized participant (AP).  APs are market participants with a lot of buying power, and they include market makers, specialists, or other large institutional investors (though sometimes the AP and the sponsor are the same entity).

The AP’s job is to buy up the securities in the index that the ETF will hold. For example, if the ETF wants to track the FTSE 100, then the AP will buy shares in all the FTSE 100 stocks in the same weights as the index, put them in a trust for holding, then deliver those shares to the ETF provider. 

In exchange, the provider gives the AP a creation unit, or a chunk of ETF shares in equal value to those underlying securities. Creation units can range from 10,000 shares up to 600,000, but the most common allotment is 50,000 shares. The AP can then turn around and resell these ETF shares for a profit on the market. 

Because this transaction is an in-kind trade, in which securities are traded for securities, no taxable event is initiated. And nor are the securities that were placed in the trust account impacted by the buying and selling of ETF shares on the open market. It’s a win-win for everyone.

Creation isn’t just limited to when a fund first starts; in fact, it happens throughout the lifetime of the ETF. It also works in reverse: The AP removes ETF shares from the market by buying enough to form a creation unit, then delivers those shares to the sponsor in exchange for an equally-valued amount of the same securities in the fund. This is known as redemption.

Redemption is also a tax-favorable process, as shares with the lowest cost basis can be given to the AP, thus increasing the cost basis of the ETF’s holdings and minimizing cap gains. The AP doesn’t care one way or another what the cost basis of their shares are, because their tax liability is based on the price they paid for the ETF shares. So when the AP sells the shares of underlying stock, any gain or loss incurred has no effect on the ETF—thus shielding investors from the tax implications of transactions made by others invested in the fund.

Benefits of creation/redemption

Creation/redemption does more than just provide the market with ETF shares. It keeps fund share prices in line with the underlying net asset value (NAV) of its constituent stocks via a mechanism known as arbitrage.

As mentioned before, markets aren’t perfectly efficient. Sometimes, through the normal process of supply and demand, an ETF’s shares become more expensive than the sum of its underlying securities; that is to say, the ETF is selling at a premium. Should this happen, an AP can buy up the underlying shares, form a creation unit and exchange it, then sell those ETF shares on the market for a profit. This has the effect of increasing supply and bringing the ETF’s price back down toward its NAV. 

Likewise, if the underlying securities become more expensive than the fund shares (that is, the ETF is selling at a discount), then the AP can purchase a creation unit’s worth of shares and redeem them for the underlying securities, which can be resold for profit. This reduces supply, pushing the ETF share price higher back toward its NAV. (The creation unit itself is destroyed.)

Either way, over time these buying and selling pressures even out, and generally the ETF’s market price stays in line with the market price of its underlying securities.

Further reading: Tracking error 

Premiums and discounts, as discussed above, are usually fleeting phenomena. But some tracking error, or deviation in a fund’s performance from that of the index it tracks, is more persistent – and unavoidable.

For example, an index fund will always underperform its benchmark by its expense ratio, which is the cost to keep the fund running. This is known as expense drag, and over time it can have a dramatic effect on returns. Some ETFs will inherently be more expensive than others, depending on the composition, liquidity of the underlying asset classes, methodology and more.

There are some ways that indexers can minimize the transaction costs required to replicate the index, which in turn can mean cheaper expense ratios for investors. One example is to time index share weight changes, such that several changes are bunched together, meaning less frequent buying and selling of shares.  (This can lead to dilution in methodological purity, however.)

Further reading: What makes a good index?

Although cost is often one of the most important variables in choosing an ETF issuer, it’s meaningless when evaluating the index brands backing those funds. Other yardsticks are far more useful, including:

Comprehensiveness
Representation means more than simply which securities an index tracks and in what weights. Seek out an indexer who takes into account geopolitical events, regional trends and cutting-edge academic research for the most complete market snapshot possible.

Global Leadership
Today’s markets are truly global; indexers should be too. Look for indexers who offer more than just presence in overseas equities, but who are globally-recognized authorities in the foreign markets they cover.

Innovation
Ever-evolving markets means indexers must stay on their toes and adapt. Look for indexers who aren’t afraid to rethink and improve their index construction or selection criteria, as well as constantly push to identify and represent important new market-moving trends.

Knowledge
A strong index provider doesn’t rest on their laurels; they always seek to know more and share those findings with investors. That means publishing research on new trends and improving the breadth and depth of their indices, so you can better understand the total market picture. 

Trustworthiness
In an industry with so much misinformation, credibility is everything. Look for an indexer who not only commits to independent oversight of their indices, but also cultivates relationships with global finance authorities you trust.