Mark to market: Dividends and the issuance and redemption of ETFs
Mark answers a reader question about the mechanics of ETFs.
Question:
Hi Mark,
With ETF providers now announcing monthly ETF units issued and redeemed I cannot understand the process of redeeming units when more than this number are issued in the same month. What happens to say the dividends that these units earned? Are they left in the pool for the units still in the fund.
As more units are issued are the existing units being “watered down”?
With more of us investing in ETFs there are obviously technicalities that we retail investors do not know of or understand.
Answer:
There are two different concepts in this question. The first is how ETF units are created and redeemed.
ETF creation and redemption
Buying an ETF unit is buying an ownership stake in a basket of other securities. For the sake of this example we can use the Vanguard Australian Shares ETF (ASX: VAS) which tracks the ASX 300. Each VAS unit contains a portion of the 300 largest companies in Australia.
The interactions of buyers and sellers of those individual shares will cause the prices to fluctuate over the course of the trading day. Those changes in share prices of the constituents of the ASX 300 will cause the index to fluctuate. That is how an exchange works and how prices are set.
An ETF also trades on exchange which means the price of an ETF is set by supply and demand which is dictated by buyers and sellers of the ETF. A mechanism is needed to link the price of the ETF with the price of the basket of individual shares the ETF tracks – in this case the ASX 300 index. If not, the buyer of the ETF / basket of shares may be paying too much or too little.
This is where authorised participants or market makers step in. These are trading desks at investment banks with the ability to exchange baskets of shares for ETF units and vice versa. Their motivation for making these exchanges is arbitrage or riskless profits.
When the basket of shares is worth more than the ETF unit the authorised participant will buy an ETF unit and exchange it for portions of the 300 shares and sell them. If the ETF unit is worth more than the basket of shares the authorised participant will buy the shares, exchange them for the ETF unit and sell the unit.
These actions alter the supply and demand dynamics for the ETF units and bring them in line with the price of the underlying holdings. This system doesn’t keep an ETF and the basket of shares at exactly the same price.
There are slight differences between the ETF unit prices and underlying holdings if those underlying holdings in the ETF are very liquid and slightly larger differences if they are not liquid. The level of liquidity impacts the cost for the authorised participant to create and redeem ETF units and therefore the premium or discount amount that creates an arbitrage opportunity.
Below is an example from VAS where there is a 0.08% premium.
Mechanics of a dividend payment
When a dividend is announced there will be a record date and a payable date. The record date is the date when the holder of the share is owed the dividend. The payable date is when the dividend shows up in your account. If you sell the share after the record date but before the payable you are still entitled to the dividend.
This is fair to both parties because the share price drops by the amount of the dividend on the record date. If a share is $25 at the market close the day before the record date it will drop to $24 before the market opens.
When it comes to an ETF issuance or redemption it is simply exchanging an ETF unit for a basket of shares and vice versa. Because the share prices have been adjusted by the dividend and the dividend will get paid to the owner on the payable date it is all fair to every party involved.
Have a question? email me at mark.lamonica1@morningstar.com
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