How Does an ETF Come into Being?

Even if ETFs are still overshadowed by stocks, they nonetheless have become an indelible part of the financial industry. Their popularity has constantly been growing even on the Swiss stock exchange, which in the year 2000 was one of the first in Europe to launch an ETF segment. Market participants trade approximately 50 billion Swiss francs worth of ETF shares annually on the Swiss stock exchange (based on data on the last three years). Worldwide, the volume of total assets under management in ETFs amounts to around 11.5 trillion US dollars today. That’s an enormous sum. To illustrate its immensity, if everyone on Earth were invested equally in ETFs, that amount would work out to around 1,430 US dollars per person.

The acronym ETF stands for “exchange-traded fund.” A mutual fund raises money from investors in order to invest it in a typically well-diversified basket of stocks or other assets. Each investor owns individual shares in a mutual fund, but does not have any influence over when, which, or what amount of assets are bought or sold. Those decisions are the sole purview of the fund manager. Whereas managers of active mutual funds personally choose the securities in which investors’ money gets invested, the vast majority of ETFs are passively composed of securities contained, for example, in an index, which is called the “underlying.”

The underlying is a financial instrument that an ETF tracks. The underlying for most ETFs is an index. The ETF tries to replicate the performance of that index as precisely as possible. The composition of an index follows clearly defined rules, with key criteria being the market capitalization of individual stocks, their tradability, and their weight in the index.

Let’s take for an example the SMI (Swiss Market Index), the blue-chip index in Switzerland. If you buy an ETF tracking the SMI, you invest in the 20 largest publicly traded companies in Switzerland simultaneously. With an ETF on the MSCI World Index, you invest in approximately 1,600 stocks from all around the world. Since the composition of indices is completely transparent, investors can understand with precision what the underlying consists of and what is packed into an ETF, particularly when physical replication is employed.

There are two ways to replicate an underlying: physically or synthetically. Physical replication means that the ETF directly holds the constituent stocks in the underlying index with the exact same weights as in the index. For the portfolio in our example using the SMI, this means that the fund manager acquires many more shares of Novartis, which accounts for almost 17% of the SMI, than shares of Swisscom, for instance, which has a weight of 1.24% in the index (as of September 2023).

If an ETF holds only a subset of the index constituents, that means it employs a sampling methodology. It uses analytical tools and mathematical optimization techniques to identify a subset of the index constituents that delivers a return similar to the one yielded by the original full set of index components. The fund manager, for instance, completely omits small stocks and weights large stocks more heavily in exchange. This methodology comes into play mainly for indices that contain a lot of stocks, such as the MSCI World.

An ETF employing synthetic replication does not hold the underlying stocks in its possession. Instead, it holds a swap agreement with a counterparty, usually a financial institution. The fund manager thus does not have to buy the stocks itself, but receives the return on them in exchange for a fee. This replication method can prove to be more cost-efficient because it eliminates trading and custody expenses, though it does entail counterparty risk.

ETFs trade on securities exchanges, which means that the price of an ETF also depends on supply and demand – theoretically. However, a creation-and-redemption mechanism exists to keep the price of ETFs from deviating from the underlying net asset value. Authorized participants (APs) have the right to create or to redeem blocks of ETF shares to ensure that the price of the ETF is always determined solely by the underlying net asset value and not by supply and demand. For example, if the underlying net asset value (NAV) is below the price of the ETF, an AP brings the ETF’s price into line with the NAV by buying the underlying and then converting it into ETF shares.

Most APs are financial institutions. SIX, too, supplies service offerings in this context: its ETF- and index-data provider Ultumus provides the COSMOS platform for the creation and redemption process.

In order for an ETF to get listed and start trading on the Swiss stock exchange, both the product and its issuer must meet an array of regulatory requirements. Both are scrutinized by the Swiss Financial Market Supervisory Authority (FINMA) and by SIX Swiss Exchange’s regulatory unit (SIX Exchange Regulation (SER)). It takes independent approval from both authorities for an ETF to be admitted for trading on the Swiss stock exchange. Besides arranging creation and redemption, a market maker must also be identified.

For each ETF, there is at least one market maker, though there can also be more than one, which normally ensures more attractive prices. A market maker is bound by contract with a securities exchange to provide continual liquidity and to constantly set bid and ask prices for ETFs to guarantee their tradability. The biggest market maker on the Swiss stock exchange is Virtu Financial, which sets prices for 1,545 of the more than 1,700 listed ETFs.

ETFs offer a wide array of benefits. Thanks to their transparency, they are easy to understand because index constituents and ETF holdings are disclosed to the public on a daily basis in most cases. ETFs offer excellent diversification opportunities – be it across 20 SMI or 1,600 MSCI World stocks – with just a single transaction. The vast range of products to choose from enables investors to invest across a wide spectrum of themes and asset classes and, in so doing, to spread risk even more effectively. Moreover, ETFs feature lower transaction and management costs than conventional mutual funds. In addition, ETFs – like mutual funds, too – are classified as ring-fenced assets and are thus subject to the same protection. This means that the invested money is segregated from the fund company’s assets and is protected in the event of insolvency.