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Creating (or Redeeming) ETFs on the Fly

Eileen Rominger, director of the Securities and Exchange Commission's division of investment management, testified last month before the U.S. Senate that the commission is reviewing whether the widespread use of exchange-traded funds is contributing to market volatility.

Scott Burns, director of ETF research at Morningstar, says no. Yet critics label them as "new weapons of mass destruction" that may be turning financial markets into casinos on steroids.

Regardless, there's a little-noted segment of the arbitrage, trading and broker-dealer businesses that are capitalizing on the efficiency of ETFs. And they are creating and redeeming large amounts of shares in ETFs, on demand.

"There's a pretty successful community right now which is involved in the creation and redemption of ETFs themselves,'' said Nitin Gambhir, chief executive officer of Tethys Technology, which provides trading and portfolio management software to more than two dozen mutual funds.

This creation and redemption occurs off-exchange and contributes to whatever correlation that ETFs have with market movement.

"When people think of creating ETFs they think the ETF is on the exchange, I'll buy and sell,'' Gambhir said last week. "But how do they come to be? How does the amount of [shares in] an ETF go up and go down?"

Here's how the on-demand creation of ETFs can occur.

Institutional investors, aka authorized participants, typically buy or sell shares of an ETF directly from or to a fund manager, in large blocks of tens of thousands of shares. These are known as creation units.

These can be exchanged for baskets of the underlying securities.

Some authorized participants, such as broker-dealers, act as market makers, using their ability to exchange creation units with their underlying securities to provide liquidity in a given ETF. Such participants may actually create new creation units, using internal inventories of shares of underlying stocks or additional purchases.

For instance, say a broker-dealer gets a call from an institutional investor to buy 500,000 shares of an exchange-traded Select Sector SPDR utilities fund that that goes by the symbol of XLU.

The broker-dealer may want to hedge that purchase. One of the options: Create an ETF or redeem an ETF.

In the case of creation, the broker-dealer would accumulate the right proportions of shares in the components of the ETF and in sufficient quantity to form a Creation Unit (typically 25,000 to 60,000 shares of the ETF) and present them to a repository of the Depository Trust and Clearing Corporation as if they were shares in the fund.

The creator or definer of the ETF, such as State Street in this case, gets payment for the licensing fees associated with the expansion of the size of its fund and the amount of shares in circulation increases.

In reverse, the broker can present the shares for redemption and get back shares in the component stocks.

"You can create it on the fly, really. So at the end of the day, you would basically have created a new ETF," Gambhir said. "A new amount of an ETF would be outstanding."

This would not be a mirror copy of the fund. "It will actually be the same ETF," he said. "You can create and redeem ETFS at virtually any time. This ensures that ETFs do not deviate significantly from their fair value. That's why ETFs are efficient.''

This is one of the reasons why ETFs of various sorts are used to capitalize on the volatility of an event such as the Standard & Poor's downgrade of U.S. debt or the nervous prospect that Greece may have a public referendum on whether to stick with the Euro and the austerity that that now will entail.

The on-the-fly aspect is particular to ETFs, Gambhir said.

"That's the difference between ETFs and closed-end funds," he said. "Closed-end funds you can't create and redeem on demands. That's why you see discounts and premiums come up. With ETFs, you don't see that."

This creation and redemption of ETF shares on the fly is a "pretty common activity," at this point, Gambhir said. And it is appealing because it is "faster, easier, cheaper" than buying the individual stocks, often.

Whether the addition of more shares in ETFs adds to whatever market volatility there is, remains to be proven.

But, are ETFs a high source of correlation? "We certainly think there is a connection,'' Gambhir said.

If, for instance, ETFs were the only kind of financial instrument traded in a volatile day, the correlation would be complete, a one. If, after an event such as the U.S. debt downgrade, 60% of trading in equities is conducted in ETFs, the connection is inescapable. As it is, ETFs generate 35% to 40% of exchange trading volume, according to Morningstar.