One question to you and her: How can one tell if an ETF uses derivatives to track an index versus one that doesn't, i.e. strictly holds the underlying stocks directly?
Is looking at the "holdings" section of the ETF's page enough or is there another way?
I don't know, exactly. humble_pie suspects that regulations don't require complete disclosure on this. She may be right; I don't know enough about securities regulations.
I look at the audited financial statements and take that literally. I see enough things in there to raise my suspicions, as described below.
The holdings web page is not sufficient. You do actually have to look at financial statements. For example, pulling up IVV (the US ishares page, click Annual Report) and browse to page 19, Schedule of Investments, you start to see interesting things:
You will see under several sector categories that they list some stocks, but not all the stocks of the S&P 500. There are many placeholders that say "Other securities", for pretty substantial %s of the ETF. Those are probably derivatives like futures, or who knows what else. Some of them appear like that because the actual stocks are out on loan (securities lending). Many stocks are missing.
There is also a section showing futures contracts. They hold S&P 500 E-mini contracts, so to some extent, IVV is mimicking the S&P 500 using index futures.
Determining the extent of the futures exposure (in lieu of real stocks) is tough to assess. It's hard to understand because the value of the futures usually appears to be tiny. What people forget, though, is that futures are very highly leveraged
. I don't remember the exact numbers, but it's something like, $10 million in futures is equivalent to $300 million or more in notional exposure.
I think IVV and the other iShares core funds are one example of derivatives infiltrating what should be a simple, plain ETF. And remember that Canada's XUS just is a wrapper around IVV, so you have all the same futures fun.
It's very tricky to dissect actually. I usually look out for any sign of derivatives holdings, and then avoid them. I would not invest in IVV or XUS.
How about Canadian ETFs though? Ugh, I'm not sure. I don't know if disclosure is as good with ours. Let me take a look at XAW. Again, look at the Annual Financial Statements linked at the bottom of the iShares page.
This is one of these "structured products", a wrapper of ETFs. Personally I do not like all the layers of indirection in these things (wrapping and sub-holdings).
XAW holds a bunch of other ETFs. It holds XUS which in turn holds IVV, which as discussed above, includes futures contracts (index derivative in lieu of real, individual stocks). So yes, XAW contains some derivatives and index replication techniques.
XAW's next largest position behind XUS (IVV) is XEF. According to this financial statement, it holds a monstrous list of securities in many countries. I don't see any placeholders or explicit derivatives, but then again, this is written according to Canada's securities laws (maybe as humble_pie says, they don't have to disclose replication tools or derivatives).
XEF really shows a ton of underlying securities. I just have the nagging suspicion that they can't really manage all those positions in all these securities, many of which will have limited liquidity. How could they? It just doesn't seem feasible. Go look at the list yourself. Then look up some of the stocks on European and Asian exchanges ... take a look at how little volume some of them. Random example: accesso Technology Group in the UK. This traded just 7,000 shares in the day in total.
Maybe I'm overly cynical but this just doesn't sound right to me. What happens when $50 million flows into XEF in a single day. Does iShares go out and buy another 3 shares or whatever (odd lot) in a highly illiquid security that only trades 7,000 shares a day?
Think of how big the bid/ask spread must be on something that illiquid. And XEF is moving $ in and out of that, daily? Really?
(a) if they're really doing that, this isn't particularly efficient, and there will absolutely be friction and big losses in market turmoil where lots of $ is pulled out of XEF. This would cause high volume selling on already illiquid securities in a depressed market, causing huge friction and inefficiency
(b) Or, as humble_pie suspects, are they replicating it somehow, and Canada's securities laws doesn't show us the nitty gritty details? This would be more efficient and potentially more desirable, but also gets into games.
At face value, based on what's written here, I don't see any clear signs there is sampling replication, or other derivatives. I don't know if it would show up, though. I have my suspicions. I don't know which I would prefer, (a) or (b) ! Neither is good.
Is the sheer number of underlying stocks a good indication of derivatives? For example I hold VIU which has 3,722 holdings. In the factsheet it reads:
Is the *indirectly* part referring to using derivatives or simply other ETFs?
I think that's what the language is referring to. But I don't think so clear, just based on the number of holdings.
Let me see if I can see what this "indirectly" refers to... pulling up financial statement...
There's a statement buried on page 308 which may shed some light on this:
Additionally, the Funds may use futures contracts to maintain full exposure to the stock market, maintain liquidity and minimize transaction costs. Funds may purchase futures contracts to immediately invest incoming cash in the market, or sell futures in response to cash outflows, thereby simulating a fully invested position in the underlying index while maintaining a cash balance for liquidity.
I do see some evidence of futures existing in many of these funds, but the accounting of it really isn't clear to me. To be honest, I can't tell from these financial statements what's going on.
Here's my guess. VIU, like XEF, shows an absolutely massive listing of individual securities. Tiny holdings (like 233 shares) in some totally illiquid foreign stock. How the heck can this seriously be managed, given that the various shares trade in different time zones, out of sync with Toronto trading. Apparently they are buying 1 share or selling 2 shares here or there in illiquid foreign markets, matching fund inflows/outflows of millions of $ in Toronto. Really?
Maybe that's why the futures are used, replicating index exposure, and then perhaps they wait and group the securities buy/sells into larger blocks (which would be more efficient).
Sorry... no clear answers. With those US funds, it's pretty clear they hold futures, and are doing something else which results in missing securities (could be replication, estimates, securities lending, or futures in lieu of stocks).
With the Canadian funds, it's less clear to me, but the financial statements seem to pretty explicitly state derivatives are used for "simulating a fully invested position".