Every day for the past several years, sometime after 3pm, bullish market participants exhale a sigh of relief when as if out of nowhere, an "unexpected" surge of buying lifts stocks into the 4 pm close. There are several explanations for what some have dubbed if not Divine, then certainly centrally-planned intervention. This is the time when ETF creation and (far less frequently) redemption takes place. As a result, in a world in which the bulk of liquidity has shifted away from single name stocks and even futures toward ETFs, trends in the creation and redemption of ETFs are key to watch to determine how the market may move purely for to technical reasons (since fundamentals died some time in 2009). Which is why we note, with little surprise, that according to SocGen, Equity ETFs posted a record level of monthly creations in October, driven by US, regional eurozone and UK indexations, perhaps explaining the relentless levitation of the market on ever lower volume especially in the latter part of the day.
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More details from SocGen:
Equity ETFs posted record monthly creations in October despite $1.3bn redemptions on the iShares Core DAX UCITS ETF.
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Excluding these redemptions, German indexations would have shown $700m creations. More broadly, we observed renewed interest in European equities (bar Italy), in particular in the eurozone regional and UK benchmarks, even though European markets underperformed in spite of the AQR results. The main contributors to ETF share creations were however US benchmarks with $4.2bn new shares, which did not look contradictory to the US macro recovery. By contrast, EM equity ETFs – and EM bond ETFs to a lesser extent – reported monthly redemptions, not seen since March 2014, probably affected by concerns about global growth, liquidity restrictions and fears of deflation.
The complete breakdown by equity ETFs:
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How does SocGen keep track of ETF creation and redemption? It explains below.
Methodology
ETF Market Signals aims to provide a concise picture of investor risk appetite based on capital markets and macroeconomic data. For this purpose, we monitor two key indicators, ETF creations/redemptions and ETF premiums/discounts. Our universe currently includes all ETFs listed in Europe.
ETF share creation and redemption
ETFs create and redeem shares on an ongoing basis like all other open-end funds. The ETF share creation/redemption mechanism is, however, unique in the sense that it exclusively occurs between ETF promoters and so-called Authorized Participants (AP). APs are typically market makers or broker-dealers who contractually buy (sell) shares of an ETF directly from (to) the fund in exchange for baskets of the underlying securities or cash. The creation/redemption mechanism helps provide liquidity to the secondary market.
For each ETF, share creation/redemption is calculated by multiplying the change in shares outstanding over the period (week or month) by the ETF Net Asset Value (NAV) at the end of the period. The source for this market data is Bloomberg. The creations and redemptions are then summed to calculate aggregate creations and redemptions by ETF category.
We calculate the ratio of ETF share creations or redemptions to assets under management (AuM) at the beginning of the period. This is to remove the bias from strong disparities in ETF size, and it highlights the significant progress in smaller categories.
Creations and redemptions provide a good picture of primary market activity but do not fully reflect investor sentiment. ETF shares are not systematically created or redeemed to meet client orders, but this occurs only when secondary market liquidity is not sufficient to meet investor needs, or when it is less costly to create or redeem than to purchase or sell ETF shares in the secondary market. The question is then how to capture the secondary market direction to fully gauge investor sentiment. This can be achieved by analyzing ETF premiums and discounts as explained below.
As ETFs represent a limited percentage of the market, share creation/redemption monitoring can be misleading as an indicator of overall activity within the market (European ETPs account for $420bn, only 5% of the Stoxx 600 market cap). That said ETPs are increasingly used as a trading/market access/investment tool by market participants (traders, portfolio managers, fund selectors). As such, investments made in ETPs can still provide a useful indicator of how investors are tactically adjusting their portfolios.
Now, to mitigate the lack of representativity, we ensure that 1/ noteworthy flows in a given ETF market segment do not come from one single ETF but rather several; and 2/ noteworthy flows on a given ETF do not come from one client (e.g. is the result of an isolated asset allocation decision) by liaising with ETF promoters to get some feedback about client activity. In addition, we may cross-check our observations with the US ETP primary market activity ($1,600bn of AuM).
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Now if only someone could create an ETF (preferably 3x levered) that only buys itself when other ETFs are in the process of creating ETFs, then the first momentum driven perpetual engine will finally be a reality.
