Three Ways ETF Issuers Handle Illiquid Securities

Each of the methods ETF issuers use to handle illiquid index components has its own pros and cons, which can be reflected in the performance of ETFs tracking the same index

Morningstar ETF Analysts 23 December, 2010 | 3:29PM
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Each Method of Handling Illiquid Index Components has its Own Pros and Cons
Unlike traditional actively-managed open-end funds which aim to best their benchmark, the goal of index-linked passive investment vehicles like ETFs is to track their benchmark index as closely as possible. Aside from the inevitable management fees, one of the biggest obstacles to perfectly tracking the performance of an index is the costs involved in buying and selling the underlying holdings. This applies to both physical- and synthetic-replication products alike, albeit in different ways.

In the case of physical-replication ETFs, the fund itself does not actually go into the market to buy or sell securities. Instead, on the primary market, authorised participants (APs) purchase baskets of securities which they then swap for new shares in the ETF. Fierce competition for the trading profits from buying or selling ETF shares versus their portfolio of securities keeps ETF market prices close to their net asset value. But these arbitrage opportunities can sometimes be insufficient to entice APs in cases where the index contains illiquid securities that would cost far too much to buy or sell. The cost of this market impact for APs is ultimately be borne by ETF investors in the form of a wider spreads to buy or sell in the secondary market.

The main advantage boasted by synthetic or swap-based ETFs is that they track their benchmark index with higher fidelity than physical replication funds. Within synthetic-replication funds, the fund enters into a total return swap, typically with a large investment bank. The fund will receive the performance of its reference index, in exchange for a swap fee and the performance of the collateral or substitute basket. The counterparty cares about the liquidity of the constituents of the ETF's underlying index because it will often buy or sell those securities in an effort to hedge away the risk it assumes by agreeing to provide the index return. Much as is the case within physical replication vehicles, the costs of tracking indices containing less liquid or difficult to locate securities will ultimately be borne by investors in the form of higher expense ratios, big spreads versus the NAV on secondary markets, higher swap fees, or--most likely--some combination thereof.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.