Supply and Demand of Exchange-Traded Funds in the Market - Research Paper Example

Running Head: Supply and Demand of ETFs in the market Supply and Demand of ETFs in the market Supply and Demand of ETFs in the market 1. ETFs Exchange-Traded Fund (ETF) Exchange-Traded Funds started trading in the stock exchange market over 15 years ago, but they have been gaining increased popularity against mature funds in the recent past. Exchange-Traded Fund is a security which tracks a commodity or a basket of assets like index funds, but it trades like stock in the stock market. ETFs can also be referred to as the middle children when it comes to the trading of stocks. Exchange traded funds are more innovative financial products offering the benefits of mutual funds while at the same time also offering the flexibility to have stocks. The market value of an individual ETF through out a single trading day depends on demand and supply for each and every ETF. They follow Index all through, but they act like Equity. ETFs can also be used to refer to those investment companies which are classified as Unit Investment Trusts (UITs) or open ended companies. Exchange-Traded Fund usually experience changes all through the day as they get to be bought and to be purchased. Exchange-Traded Fund does not have net asset value like mutual funds since it trades like a stock. How ETF is created? The leading country in the development of ETF is Canada. It creation has roots in Toronto Stock Exchange with Toronto 35 Index Participation Units. The creation of ETFs starts when a professional investor like an investment bank places a whole stock portfolio with a fund manager where they exchange the basket of securities underlying the Index with the provider of ETF for new ETF shares. That is, the professional investor then receives a given quantity of ETF shares in return for the deposit. These shares can then be traded in the exchange market where they can be sold or bought by professional investors or retail from all parts of Europe. Creation units refer to large blocks of ETF shares which usually range from 100,000 to 200,000 shares per unit. The designated or professional investor or brokers usually break these creation units into individual ETF shares which then trade in the stock exchange. The creation and the issuance of ETFs consist of two markets which include the primary market which creates the ETFs and the secondary market which buys or sells the ETF units. The creation of ETFs therefore takes place in the primary market between the authorized participants and the fund. “In kind” creation on the other hand takes place in authorized participants and more so large financial institution. The ETF shares are created by the deposit of portfolio of stocks into the applicable fund, and this is done in exchange with an institutional block of ETF shares which is 50,000 in most cases. This is referred to as “in kind” creation as it deals with the exchange of the basket of stocks for ETF shares instead of using cash. The decision to create ETF shares depends on several factors which include the to fill orders, the need of inventory creation or the need to take advantage of any arbitrage opportunity which may arise. The basket of shares deposited by the authorized/professional participants is a representation of the weight of those shares in a given index like NADAQ-100 Index which is then accompanied by a given cash component in order to cover accrued dividends, creation fees, capital gains less the losses that may not have been reinvested from the last distribution, and interest on dividends as well as small cash amounts to cover all the differences which may result from rounding off the number of shares needed for deliverance. A graph on the creation of ETFs Source: http://www.nasdaq.com/indexshares/eqqqETFsInDetail.stm 2. Supply and Demand of ETFs Analyze supply and demand of ETFs The creation/redemption mechanism of EFTs gives the ETFs an exposure into the market and allows the ETF to be cheap, highly transparent and highly efficient than the traditional mutual funds. As a result, the demand of ETFs is high compared to that of the traditional mutual funds. Since ETF trades in the stock market just like a stock and do not trade at their net assets values of their underlying holdings, they are subject to fluctuations in price during any trading day due to the forces of supply and demand. The supply and demand for ETFs are driven by their portfolios underlying values as well as other factors. This creates a potential for the ETFs to be able to trade below or above their underlying portfolio value. Authorized participants (AP) are engaged in most of buying and selling of ETFs. When the AP sense that there is a high demand for ETF shares which is usually manifested when the share price of the ETF trades at a premium to its net asset value, the AP usually go into the market to create new shares. Whenever the authorized participant sense an increase in demand from investors who are looking to redeem the shares which is manifested when the ETF shares price trades at a discount, they usually process redemptions. Market makers are the professional traders who are appointed by the issuer of the shares in order to provide liquidity in the secondary market for the ETFs. These market makers use the underlying holdings in the calculation of the price which will reflect the underlying securities. ETFs in portfolio ETFs in portfolio a. ETFs help investors in decision making ETFs are very important in the investor’s portfolio and therefore, investors should make use of this investment vehicle. ETFs should be used in the construction of investment portfolios. As an investor, there is the need to make a decision on asset allocation. This calls for the use of the right mix of bonds, stocks, commodities and cash in the investor portfolio and being well diversified within each class of assets as this will have a huge impact on the investment returns. ETFs can be an easy way to help the investor in gaining this diversification. The ETFs are flexible, cheap and tax efficient and will therefore help investors in gaining access to asset classes and sectors which would have been closed off to individual investors. Figuring out the right asset allocation is the first step towards the construction of a portfolio using ETFs. Investors should consider an aggressive approach which is weighted towards equities while those people within a few years of being in need of their money will stick to investments which are more conservative. b. ETFs play a role in the diversification and growth of the underlying ETFs can also help the investor to gain an exposure to all areas in the market which may be undervalued. Short term gyrations in the market usually leave some sectors and some sub-sectors trading for a less value than their intrinsic worth. ETFs should therefore be used in investment portfolios as they help the investor to boost their returns over a given time since the undervalued sectors usually converge their estimated worth in the long run. Investors should seek the margin of safety of the investments prior to the investments as there a fair amount of uncertainty which is assigned to estimated shares worth. c. ETFs spur growth on investor portfolio ETFs have another role in the investor’s portfolio as it provides them with access to alternative classes of assets like currencies and commodities. There areas used to be only available to individuals who high-net worth and institutional investors but could be used by the investor to diversify their portfolio. Many investors would like the classes of this asset to represent only a small fraction of their total or overall holdings. However, the presence of these assets in a portfolio can be quite helpful to investors as they can be uncorrelated to a broader stock of the market returns. What affects ETF supply and demand? The supply and demand of ETFs in the market is highly affected by the fluctuations of the prices of the shares. The liquidity of the EFT shares also highly affects their supply and demand. 3. Market for ETFs Types of ETFs 1. Fixed income funds Financial professionals usually advise investors to n fixed income securities like bond ETFS. This is because these bonds reduced the volatility of the portfolio while providing additional income at the same time. Bond ETFs are highly available in many types like equity funds. 2. Commodity funds It is quite important for an investor to understand the reasons behind his or her interest in the commodities. Over the past years, commodities were found to have a little price correlation with equities which provides investors with a low volatility. It is not enough for the investor to bonds, cash, stocks, commodities as well as real estate in their portfolio, and that is why they should diversify to different classes of assets. Investors can buy commodity ETF which is able to track changes in prices of a particular commodity like silver and gold. 3. Currency funds The world currencies are becoming highly volatile which is accompanied by the fading of the reserve currency of the US dollar. Those investors who wish to protect the value of their investments in the US must seek for options which would help them in providing a hedge against the dollar whose value is depreciating. Investing in foreign stocks may not be helpful in this case as the foreign stocks are highly correlated with US stock. Index versus Active International market 4. Conclusion Future of ETFs Read More