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ETF Basics - Creation and Redemption

April 5, 2017

 

The first marijuana-focused ETF began trading this morning on the TSX under the ticker HMMJ. One of the most commonly asked questions we've received is..."does a cannabis ETF exist?" Unfortunately until today, we had to answer "no, not yet." Now that there's finally a cannabis-focused ETF, it seems fitting that we educate our readers about the inner workings of an ETF.

On the surface, ETFs seem really simple. Investors buy shares of a fund the same way that they would buy shares of any individual publicly traded company. Unlike mutual funds, ETFs trade all day long allowing investors to get in and out of positions with ease. When an investor buys into an ETF, what's happening behind the scenes? The process we're going to dive into today is called the creation / redemption process. 

 

Basics

 

First and foremost, an ETF is like a vehicle carrying a pre-determined basket of underlying securities. Instead of buying shares of each individual company that makes up an industry or geographic region, ETFs allow investors to take the convenient basket-style approach and buy them all packaged together. This beautiful bit of financial engineering would not be possible without the creation / redemption processes in place. 

 

Authorized Participants

 

For any ETF, there are financial intermediaries enlisted to assist in the creation of shares in the fund called Authorized Participants, or APs. Whether a broker, a market maker, or any other type of financial intermediary, APs are what keep ETFs functioning smoothly.

 

Each ETF has an underlying index that the fund seeks to track. For the Horizons Medical Marijuana Life Sciences ETF (TSX:HMMJ), that's the Solactive North American Medical Marijuana Index. The North American Medical Marijuana Index currently consists of 16 of the leading companies in the cannabis industry, and this predetermined basket of companies make up the list of underlying securities held by the newly launched ETF. 

 

This new ETF is pretty popular, and we'd be willing to bet that Horizons will be getting a substantial amount of assets under management, or AUM, for this fund. If HMMJ's share price rises more than the underlying index, this creates what is called a premium to net asset value, or NAV. NAV is all of the fund's assets minus all of the fund's liabilities at any given time. When a fund is trading at a premium or discount to NAV, this creates opportunity for the fund's Authorized Participants. 

 

Creation & Redemption

 

When an ETF is trading at a premium to NAV, the AP's job is to now buy up the underlying securities that the fund is supposed to hold, in the proportions that the fund is supposed to hold them.

 

In the case of HMMJ, this means 10% Scotts Miracle-Gro, 10% Aurora Cannabis, 10% Aphria, and so-on. Once the AP has acquired the proper underlying basket of stocks, they are ready for the creation process. 

 

The AP delivers the basket of underlying stocks, and in return they are given an equivalent block of newly created shares in the ETF that they can sell into the market. This block of shares in the ETF is called a creation unit, and usually these are blocks of tens of thousands of shares in the ETF.  If each unit of underlying stocks cost the AP $10, and each share of the ETF is trading at $10.50, this provides an opportunity for the AP to profitably create more shares of the ETF in order to satisfy demand and re-align the fund to its NAV. 

 

This creation process also works the other way around, and that's what's called redemption. The AP buys up blocks of the ETF on the open market, and exchanges them for the equivalent shares in the underlying companies. 

 

Why Does this Matter?

 

The creation and redemption processes are extremely important for keeping an ETF running smoothly. On days like today when investors a piling into a new ETF like HMMJ, it's almost certain that the fund deviated from its NAV today. This means that there was an imbalance of supply and demand for the fund, which is only fixed by the creation / redemption process.

 

APs see the premium to NAV in HMMJ, so they jump into the markets to scoop up shares of the 16 component companies to exchange them for more HMMJ. In this situation, everybody wins. The creation / redemption process allows the APs to bring supply and demand back to equilibrium, and prevents investors from overpaying for a given ETF. 

 

AP Competition

 

Some readers may be wondering what prevents an AP from letting a fund rise to being hugely overpriced compared to NAV. Thankfully, there are handfuls of APs all competing to keep markets in-line. If one AP lets a fund deviate too far from NAV, another AP will jump on the opportunity to make nearly risk-free profits on the creation / redemption arbitrage.

 

This process keeps fund fees low, and allows investors to continue using ETFs as a cheap and convenient way of gaining exposure to different assets and strategies. 

 

Conclusion

 

Hopefully this was a useful primer on the creation and redemption processes. Given the launch of HMMJ today, this lesson will be of increasing importance to cannabis investors. Happy trading!

 

D/M/O

 

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