There have been considerable talks about introducing Exchange Traded Funds (ETFs) to the capital market of Bangladesh for some time. ETF, to many, is an innovative financial instrument that meets specific investment needs of investors which the traditional instruments cannot. This capacity to meet certain investment needs has made ETF an attractive and popular investment product worldwide. An October 2013 estimate showed that there are more than 2.3 trillion US$ assets that are traded worldwide under the umbrella of ETFs. The majority of the global ETF market is controlled by the USA, trading around 1.97 trillion US$ assets under ETFs as of December 2014.
From the facts and figures shown above, it is quite obvious that ETFs are quite popular around the global investors. So, it would be a great initiative if ETFs can be introduced in the capital market of Bangladesh.
What is an ETF? As its name says, its basic structure stands on a fund and an exchange trading mechanism. Simply speaking, ETF is just like an investment vehicle or a fund where shares/stocks from different sectors are pooled and against that pool, ETF shares are issued to investors so that they can get exposure to multiple stocks by owning one individual ETF share. Investors can trade individual ETF shares through an exchange by brokers/ dealers. This is obviously a cost-effective tool to get exposure to multiple stocks as investors do not have to own multiple shares now; they can go for ETF shares instead.
An ETF can track an index by including the shares/ stocks in its pool at the same proportions that are maintained to run the index. So, if an ETF is run such that it will track DS30 Index, it will include the same shares and in the same proportions/weights that are maintained in DS30 Index. In this case, the investors do not have to buy individual shares/ stocks separately to get exposure to the DS30 Index. They can simply buy ETF shares and trade subsequently.
OVERALL MECHANISM: Now, how can this ETF mechanism be implemented? There are several parties to consider here - fund sponsor, authorised participants (APs), market makers, the exchange, and finally investors. Let's see what they do.
The fund sponsor is the party that will always be ready to receive the underlying individual shares from APs, pool them and then issue ETF shares against the total pool value of the individual shares. The sponsor might create the fund through a trust mechanism. A trust is an entity that has defined objectives to serve its defined beneficiaries. The sponsor cannot usually do anything for its own interest.
The APs are the main parties to implement an ETF. These are the large financial institutions that actually control the demand and supply of ETF shares in the overall market. When there is a high demand for ETF shares in the market, these APs will collect the underlying individual shares and provide them to the fund. The fund will, in return, provide the APs the ETF shares. The APs will do the reverse transaction with the fund when there is a low demand for ETF shares in the market. The entire transaction is done without any major involvement of cash - it means that the transaction is done on a share-for-share basis. This sort of transaction, much like a barter trade system, is referred to as transaction done 'in-kind'.
This type of transaction will offer advantages in terms of tax efficiency for the APs because they do transactions with the fund on a share-for-share basis. So, no shares are being sold to the fund and no capital gain is being realised; so, there is no tax burden on the capital gain.
The entire process of issuing new ETF shares against underlying individual shares/stocks is called 'creation'. The opposite is referred to as 'redemption'. The transactions are done in bulk volumes. For example, when the fund actually provides ETF shares to the APs, these are provided in large 'creation units'; each unit might constitute 25,000 to 200,000 ETF shares. In the opposite case, the units are called 'redemption units'. These 'creation' and 'redemption' are basically the primary market activities.
One thing that is fundamental to the entire concept is that the overall market capitalisation is not affected by the transactions. When underlying individual shares/stocks are placed with the fund, they are no longer tradable in the market because against them now ETF shares have been issued which are being traded. The same is true when the ETF shares are placed with the fund to get the underlying individual shares/stocks in exchange; these ETF shares are no longer tradable.
Once the APs get the ETF shares in their hand, they can do three things - hold them for their own purpose, sell them to their dedicated clients over the counter, or sell them to other market-makers or even investors through the exchange. The last two activities basically start the secondary market activities which consist mainly of trading through the exchange. Trading can continue for the entire day (for trading hours), like any other shares. This advantage is missing in case of traditional mutual fund units which can only be traded at the end of the day.
The market-makers are normally the brokerage houses that will constantly bridge the gap between an AP and the end customer (investor). When investors place demand for new ETF shares with a market-maker, it will channel the demand to other market-makers, the APs or even the other investors by buying the ETF shares. In this case, the market- maker can itself be an AP.
ARBITRAGE AND TRADING: Now, let's come to the basic trading activities. Each ETF share represents some other shares. So, by default, the ETF shares should exactly match with the prices of the underlying shares. However, this is not always the case because both ETF shares and the underlying shares are traded independently. So, if there is an overall higher demand for ETF shares than for the underlying shares, the ETF shares will be trading at a higher than the should-be price and vice versa.
However, in the developed capital markets where ETFs have been implemented so far as in the USA, these mismatches are short-term in nature because market participants quickly realise the arbitrage opportunity and let the price reflect the equilibrium state. Let's see how this happens.
Let's say, an ETF share consists of 3 underlying shares priced at Tk 30, Tk 40 and Tk 50 respectively. The ETF share should then trade at Tk 120. But because of higher demand for ETF shares in the market, let's assume that the share is priced currently at Tk 140. Once this mismatch is revealed, the investors, the market-makers and the APs will all buy the 3 underlying shares (because they are cheaper to buy) and sell the ETF share (because they offer higher amount when sold). All these transactions might lead to an equilibrium price of Tk 130 for the ETF share and Tk 33, Tk 43 and Tk 54 for the 3 underlying shares.
This is just a simple illustration of how things might work when ETF shares or the underlying shares might not reflect the same price. In a real world situation, the pricing will depend on so many other factors. Besides, to track down the mismatch, investors and other participants will need to look at the intra-day indicative value (IIV) and the quoted price of an ETF share. The IIV of an ETF share is that price which exactly reflects the prices of the underlying shares and is usually disclosed at 15-second intervals.
The closing IIV of an ETF share for the day is referred to as the net asset value (NAV). It is the price at which the APs can engage in further 'creation' or 'redemption' with the fund. A key challenge is that the market participants will not know in advance the exact volume of trading that is needed to reach the equilibrium state of price. This means, the mismatch can continue the entire day in both ways (an ETF share priced higher than its IIV might be priced lower after some time).
CHALLENGES FOR BANGLADESH: In Bangladesh, there will be some added challenges. Here, shares cannot be sold in short. So, a market participant can only sell shares from its own holding. This will complicate the entire picture of market efficiency and so pricing mismatches might continue.
For example, in the example shown above, the participants will, for sure, be able to buy the underlying shares. But they will not be able to sell the ETF shares unless these are in their own holdings. This will have an asymmetric impact on the overall pricing mechanism and any equilibrium pricing may only be reached after a considerable lag of time.
Another problem will be with the momentum/ trend-following investors. When these investors see that an ETF share is priced higher than its IIV, their popular perception will be that the ETF shares will be priced higher forever, which should be the opposite case instead. These investors might be in a trap of losing big chunks if they continue buying the ETF shares whereas the other knowledgeable market participants will just do the opposite - sell the ETF shares to these investors at a high price (from their own holding, if possible) and buy the underlying shares.
However, whatever the case is, as long as there is sufficient number of APs and other market-makers, the market will be close to efficient. So, on an overall basis, the ETF will be a great initiative for our market.
