Saturday Night Live’s 1976 commercial spoof attempted to categorize a product called New Shimmer. Gilda Radner proclaimed “It’s a floor wax”, while Dan Aykroyd enjoyed it on his pudding with the retort “It’s a dessert topping”. It was durable, scuff resistant and delicious!
Not quite so readily resolved is the classification of Exchange Traded Portfolios (ETPs). Broadly speaking, ETPs include Exchange Traded Funds (ETFs) and Notes (ETNs). Mechanically, they trade like common stock but create mutual fund-like exposures.
Are ETPs derivatives? Strictly speaking, ETPs are securities whose value is in fact derived from other securities. On a practical basis, however, some ETPs themselves hold derivatives, particularly the levered versions. These derivatives run the gamut from futures contracts through exchange-listed options to OTC swap contracts.
If your firm is not already using ETFs (or ETNs), it may very well be doing so soon. A recent Greenwich Associates survey (sponsored by a major ETF player) indicated that institutional use of ETFs is rapidly increasing and broadening. The breadth of offerings has given rise to a variety of potential uses, which include but certainly are not limited to:
- Create exposure to sectors, countries and regions outside the manager’s core expertise;
- Allocate to asset classes which are not intended to generate alpha (for example, fixed income);
- Hedge or shift core positions in a rapid, cost efficient manner.
Creation and redemption of ETF shares is accomplished as market demand necessitates. One or more Authorized Participants (APs) have the right, and responsibility to do so. This structure is valuable for arbitraging away potential disparities between the market price of the ETF and that of its holdings (which must be disclosed daily). For example, should an ETF’s price materially exceed the market value of its holdings, even intra-day, the AP could buy (relatively underpriced) underlying shares and redeem them for ETF shares. When the AP sells these (relatively overvalued) ETF shares, it creates a riskless profit.
This structure has another potential benefit to institutional users, who may opt to use ETF creation and redemption mechanisms to trade around brokers. Specifically, a basket of shares may be exchanged for ETF shares. Similarly, many ETF shares may be redeemed in-kind for the underlying shares. Both transactions are sizeable and neither would involve the services of a broker. This may be advantageous, but it should be recognized as a viable avenue to transact.
Unlike New Shimmer, the floor wax that might also serve as a dessert topping, defining an ETP is not merely a matter of taste. Part 2 of this article will examine some of the structural differences among ETPs, particularly those which are potentially relevant to risk and compliance.