Best Question I Ever Got About ETFs

David Frost // Market Outlook


July 28  

At first glance, they seem very straightforward and vanilla.

At second glance, they seem mysterious and misunderstood.

Here is the question that prompted me to want to know more.

What’s inside SPY?

I either knew or assumed for the longest time that SPY was made up of the proper weighting of each stock represented in the S&P500.

Most think the same way.  In fact when I began to craft my answer back to the member, I soon realized there were no facts or data in my answer, just what I thought.

Now each and every day I provide my thoughts in these pages and within the other content available to members.  However, it’s always based on data that I deem to be reliable.

Because I’m anal retentive, I felt the need to go to the source.  SPDR – State Street Global Advisors.

The first thing I noticed was this statement:

“In general, ETFs can be expected to move up or down in value with the value of the applicable index. Although ETF shares may be bought and sold on the exchange through any brokerage account, ETF shares are not individually redeemable from the Fund. Investors may acquire ETFs and tender them for redemption through the Fund in Creation Unit Aggregations only. Please see the prospectus for more details.”

On the surface, it seems like normal mumbo jumo financial and legal jargon.  For the most part, it probably is, but I couldn’t help but want to know just what the “Fund in Creation Unit Aggregations” was.

After further review, it also seems pretty straight forward.  Units issued which represent a finite number of available units allowing the fund to establish a market.  The units are exchanged for a pre determined basket of stocks.

On the surface it all sounds legit.

Until you over analyze it, like I did.

If the fund, or “units” hold a basket of securities, in this case all the S&P500 stocks, then how and when do they buy and sell all those stocks throughout the day?

Here’s an example.  Apple represents 3.2% of SPY according to the most recent data available.

Still seems fine doesn’t it?

It does, until you start to think about all other ETF’s that own Apple stock.  All the mutual funds and people that own and trade Apple stock.

How about QQQ?  Apple represents about 12% of this ETF.  And then there are the other 85 ETF’s that also own Apple.

This would mean that each and every day each of these funds who own from thousands to millions of shares of Apple would have to buy and sell based on what happened in their fund that day.

When does this trading take place?  At the end of the day?  The Beginning of the following day?  If so, there would be huge volumes on either side of the trading day and we don’t really see that on a regular basis.  Seems to be part of the mystery.

Here’s another one

So do the funds go down because the stocks in the funds go down first, or can the fund go down causing the stocks to be sold and go down second?  Look at it another way.  Does SPY move based on the buyers and sellers of SPY, or does it move based on the stocks underlying the index.  Reading the legal material you would think it’s about the stocks in the index.

Fine, but what about the funds that trade very light volume.  What happens when someone wants to sell 25,000 shares of a fund that trades an average of 18,000 shares each day.  That seller is going to drive down the price of the ETF right?  Of course.  Does that mean that each stock in the fund went down?  Not necessarily.

Are the funds just simply three or four letters that trade on their own with really no store of value whatsoever?

If the stocks are really in the funds, then how could QQQ be up while Apple was down 40% from September 2012 through June 2013?

While I understand there are other stocks in QQQ that could have pulled it higher, I’m just saying it seems fishy.

I don’t have the answers to these questions yet, but I’m working on it.

Fascinating to nerds like me.

Today’s market analysis provides some additional evidence of what’s happening inside the market…

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost