By Tim Dulaney, PhD and Tim Husson, PhD
Exchange-traded funds (ETFs) are often lauded for their ability to efficiently create or redeem shares in response to changes in demand for the fund (known as fund flows). However, new research suggests that some ETFs that hold international securities may face transactional frictions that prevent them from tracking their benchmarks as well as other ETFs.
When there is an imbalance between supply and demand for an ETF, authorized participants (APs) create or redeem shares of the ETF to increase or decrease supply to match demand. If the fund begins trading at a premium to NAV (representing excess demand), APs create shares of ETFs by delivering to the fund sponsor a basket of securities constituting one creation unit. For a fee, the sponsor exchanges the creation unit for a specified number of shares of the ETF. This process essentially works in reverse for a fund trading at a discount to NAV (representing excess supply). This process serves to remove discrepancies between the market prices of ETF shares and the NAV of the fund.
As the ETF industry has evolved, it has become more difficult for some ETFs to conduct these so-called in-kind exchanges and as a result many funds are now offering cash exchanges. In a cash exchange, the fund itself transacts the underlying securities to produce the exposure offered by the fund (as opposed to the APs). Cash exchanges are similar to the liquidity provided by open-end mutual funds and it has been shown that such short-term trading by mutual funds has a detrimental effect on the wealth of long-term investors.
Brian Henderson and Gerald Buetow have written a paper entitled "Are Flows Costly to ETF Investors?" that explores whether cash creation and redemption is costly to ETF investors. The paper was recently accepted to the Journal of Portfolio Management and should be appearing in the next few months.
The study focuses on the daily returns of ETFs traded on US exchanges with at least $25 million in AUM, average daily turnover of at least 10% of the shares outstanding and at least six months of data (excluding commodity ETFs, leveraged ETFs and currency ETFs). The sample consists of 330 funds that feature in-kind exchanges and 49 funds with cash exchanges.*
The study finds that fund flows (the net effect of daily creations and redemptions) can have a detrimental effect on the wealth of investors in ETFs tracking international benchmarks. In particular, the funds that feature cash exchanges underperform their benchmark indices by almost 2% relative to in-kind funds on an annual basis. The authors argue that a portion of the performance differential most likely results from the transaction costs shouldered by the fund due to such things as the difference in trading hours of the underlying assets and the ETF shares.
These results have important implications for the ETF market, especially for investors in ETFs that track international benchmarks, although it may be hard to avoid such frictions.
* Cash exchanges are a relatively recent innovation in ETFs and as a result their representation in the sample is relatively small.
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