Module VII·Article V·~3 min read
ETF: Structure, Mechanics, Risks
Types of Asset Management Institutions
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ETF: a revolution in investment products
Exchange-Traded Funds (ETF) have become one of the most successful financial innovations of recent decades. Combining the advantages of mutual funds and exchange-traded stocks, ETFs have transformed the asset management industry and changed investor behavior.
Structure and mechanics of ETFs
An ETF is an investment fund whose shares are traded on an exchange like ordinary stocks. Unlike traditional mutual funds, investors buy and sell shares on the secondary market during the trading day at market prices. An arbitrage mechanism keeps the ETF price close to the NAV (net asset value). Authorized Participants (AP) can create and redeem large blocks of shares (creation units) in exchange for a basket of underlying assets. If the ETF price is above NAV, APs buy the underlying assets, exchange them for ETF shares, and sell them for a profit, returning the price to NAV. And vice versa. This mechanism is more effective for liquid assets. For illiquid underlying (high-yield bonds, emerging markets, commodities), the deviation from NAV can be significant, especially during stress periods.
Types of ETF
Index ETFs track a benchmark — S&P 500, MSCI World, Bloomberg Aggregate. This is the most common type, offering cheap market exposure.
Smart beta / Factor ETF weigh components not by capitalization, but by factors: value, momentum, quality, low volatility. This is an attempt to obtain factor premiums in a passive format.
Active ETF are actively managed, but trade like ETFs. Transparency of holdings was a barrier (active managers do not want to disclose strategy), but new structures (semi-transparent ETFs) mitigate the problem.
Thematic ETF focus on themes: clean energy, artificial intelligence, cannabis, metaverse. Often launched at the peak of interest and entail increased risks of concentration and overvaluation.
Costs and efficiency
Expense ratio — the annual management fee. For large index ETFs (SPY, IVV, VOO) — 0.03-0.10%. For niche products — up to 0.75% and higher. Price competition continues to bring fees down.
Trading costs: bid-ask spreads, premium/discount to NAV, broker commissions. For liquid ETFs, costs are minimal; for illiquid ones — they can be substantial.
Tax efficiency — one advantage of ETFs in the US. The in-kind creation/redemption mechanism allows you to avoid the realization of gains and distribution of capital gains to investors.
Risks of ETF
Counterparty risk in synthetic ETFs, which use swap replication instead of physical ownership of assets. The swap counterparty may default. European regulation limits the share of synthetic replication.
Securities lending risk — many ETFs lend holdings for additional income. This creates counterparty risk and potential problems with the return of securities.
Liquidity mismatch — ETFs on illiquid underlying (high yield bonds, bank loans) promise daily liquidity, although the underlying assets trade less frequently. During stress periods, this can create problems — the ETF may trade at a large discount to NAV.
ETF and market structure
ETF growth is changing market dynamics. Index flows move all components simultaneously, potentially increasing correlations and reducing price discovery. However, empirical studies do not provide unambiguous conclusions about systemic risks.
Competition with active managers: the outflow from active funds to passive ETFs continues. This puts pressure on active manager fees and drives industry consolidation.
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