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Comment by akg_67 | Hacker News Reader

I have several concerns with index fund/ETF investing:

1. How much of the underlying stocks, that make up the Index, are really owned by the Index fund/ETF? I doubt that such funds/ETF actually own 100% of the required underlying stocks, may be using some sort of option/hedge strategy.

2. In what scenario, not owning the actual underlying stocks can be detrimental to index fund/ETF? I am looking for what may cause failure of such funds/ETF and who may lose.

3. Is index fund/ETF investing artificially inflating price for underlying stocks compared to price of the rest of the non-index stocks in the market?

4. Can index investing cause Index "Bubble"?

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For European ETF:

1.) Depends on the ETF. There is

a) Full Replication. All stocks are 1 to 1 in the ETF.

b) Swap based. EU swap ETFs can have up to 10% (but not more) in swap (what you mean by option/hedge), the rest is stocks. Oftentimes ETF issuers have an insurance on those swaps. If the swap counterparty goes bankrupt you loose that 10%.

c) optimized sampling. You have different stocks (or not all of that index) in your ETF. The idea is to find stocks that corelate closely to those in the index.

2.) By buying the ETF you "own" the stocks. ETF are regulated like mutual funds (at least in EU).

3.) ETF are only a small fraction of the worldwide trade. But obviously if your company gets into a popular index (s&p 500) you can be quite happy.

4.) If everybody would only invest in indices, the market won't play anymore and it would be smarter to buy individual stocks again. This is the index investing paradox. But very unlikely to happen.

About 4: Active investor could get a better performance than passive investors, if that situation would arise.

The problem is that "ETF" is actually quite a broad term. As far as I can tell, many ETF's do run a sort of "fractional reserve" ratio. There was an article here not long ago wringing its hands over that danger which I can't find right now.

The answer to 2 I think depends on how dividends are handled. Obviously if you hold the shares yourself, you control what happens to the dividends, and are free to take them or reinvest them as you wish.

For 3, it depends on the ratio of index trackers to managed funds in the market, but yes, this can have a noticeable effect. A share price always dips when the it's removed from one of the larger indices; you can see an example here: http://uk.finance.yahoo.com/q/bc?s=TATE.L&t=2y&l=on&... - they were removed from the FTSE100 in March 2009.

1. An index is generally creared to the target mwarket.

1. read the prospectus. if the fund is comprised of stocks as opposed to derivatives it will be comprised of stocks. Of course fund will only buy whole and large amounts of shares, so say you put 1 ETF share worth $100, the fund won't be hurrying to buy shares with it, until they got $1000000 to start buying wholesale.

2. Of course if fund is derivative based all risks associated with derivatives come into play for fund investors. Same is true for any securities that are owned by funds - their risk is transferred to shares of fund. But I think you're familiar with risks associated with equity investing.

3. Maybe, maybe not, depends on stocks and market conditions. Of course the company is "more valuable" if it's included in some popular index like S&P, but then again ETF's and funds can make purchases wholesale, so there might be some benefit too.

4. Yes, but since traditional non-derivatives based funds are linked 1-to-1 to underlying shares, I don't see a huge problem. Unlike with derivatives-based funds.

Of course fund will only buy whole and large amounts of shares, so say you put 1 ETF share worth $100, the fund won't be hurrying to buy shares with it, until they got $1000000 to start buying wholesale.

The ETF will actually never buy the shares. You can only buy existing ETF shares from other traders.

ETF shares are created by large financial institutions - JPM/GS/other big players have the option to make an in-kind trades of share in securities for ETF shares. I.e., if an ETF is 50% MS and 50% AAPL, a large trader can trade 50k shares of AAPL and 50k shares of MS for 100k shares of the ETF. (Similarly, they can perform the reverse trade.)

I don't quite understand what you're saying.

From what I understand when the ETF achieves cash position needed to generate 1 creation unit (usually 50k ETF shares, as you correctly point out), then the fund is absolutely required to purchase underlying shares that index it's tracking requires it to hold. It can't just hold cash and promise to track index nevertheless. Or do you mean that first comes the Creation Unit, and then people can buy shares in ETF?

In case of ETN there's absolutely no obligation to purchase anything, as they're simply debt of issuer; a promise to repay you in the future according to predetermined index or underlying movement.

Maybe you meant ETNs?

P.S. I re-read what you wrote, and I think what you're saying is that large institutions are intermediaries between ETF and investor. That is absolutely correct, and probably is so 99% of the time in the market anyway regardless of whether shares purchased are of individual companies or funds. But ETF is still required to hold the assets it states it will hold, that was my point.

You don't trade cash for the creation unit, you trade one creation unit of shares in the underlying securities. If 1 share of AMSETF is claimed to be equal to 0.5 shares in AAPL and 0.5 shares in MS, you hand 50k shares of AAPL and 50k shares of MS to the managers of AMSETF. They create 50k shares of AMSETF and hand them to you.

No cash changes hands (unless cash is one of the underlying assets of the ETF), so the ETF is never sitting on cash with the obligation to purchase shares.

In general, it's very unusual to hand cash to an ETF in return for shares (unless cash is one of the underlying assets). I'm not even sure it is legal to do so.

okay, I was sloppy in my description of ETF mechanics.

but from investor point of view it still works as I described - she goes to market, places bid for ETF shares. Then the process splits as following:

a) if there are sellers in the market she gets her shares from them b) if there are no sellers, market makers will still sell her the ETF shares

then once market maker accumulates enough cash from buyers, he purchases/borrows shares needed for exchange for N creation units from ETF trust.

I don't think market makers just go and create ETF shares without there first being demand for them?

It sounds like you are expecting the ETF would be creating more shares frequently which it does not. That would have to happen as a secondary offering and it would dilute the value of all the other shares in circulation, Assuming they are the same class share.

There's no dilution with ETF. When ETF shares are created (via formation of Creation Unit), the ETF holdings increase by equal amount of underlying assets. You can create as many ETF shares as market demands (until you run out of possibility to buy underlying assets).

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