XLF: One Billion Dollar Poker
September 19, 2008
By Max Rottersman

HANOVER, NH (ETFguide.com) - On September 9th, about $815 million, or about 10% of Select Sector Financial ETF (AMEX: XLF) shares were redeemed. But the order didn’t hit the market until September 11th. On the 11th and 12th XLF rose. Another order was placed for $500 million. The next day another $800 million in shares were created. That order cleared on the 16th. In the days between placing their order and settling, XLF lost 12% of its value. To some people, it may not have mattered.

Every week or so XLF contracted and conversely expanded nearly $1 billion, more than 10% of it’s approximately $7 billion assets. It begs the question, whose making (or losing) money and how?

Can the broker figure out when the retail market is going to sell a billion in XLF to the public? It’s doubtful. Perhaps the institutions are buying and selling for their own account. If so, why the big-and-quick, in-and-out?

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If you’re new to ETF investing, the ETFs you buy through your broker are created in 50,000 share blocks by very large financial institutions (called Authorized Participants, or APs). The APs must meet the Depository Trust’s capital requirements, which are very substantial. That is, an AP must have enough of the ETF’s component stocks, in custody, to create the ETFs.

A deli is a good analogy. It has cheeses in bulk and must decide if it can best sell them separately or as part of a three-cheese sandwich. A sandwich is like an ETF. It just re-packages three cheeses but has its own price. If the sandwiches stop selling, a deli might take out the cheeses and sell them separately.

For XLF, the institutions that provide the securities for the ETF sandwiches are probably Goldman Sachs, Credit Suisse, Merrill Lynch, Banc of America, Morgan Stanley, Deutsche, UBS, Citigroup, and a few others.

Unfortunately, AP trades are not disclosed to the general public. But even if they were, they might have been executed on behalf of someone else, like a hedge fund.  Compounding our difficulty, due to the settlement process, an AP trade isn't visible until at least two days after the order is placed.  

Typically, institutions create or redeem ETF shares slowly. Why bother creating a bunch of ETF shares if no one wants them? After all, it costs $500 for an institution to process an order. Similarly, a deli won’t unnecessarily run up costs by making and taking apart sandwiches. APs know better. If an AP submitted orders willy-nilly they would run up six-digit expenses.

On a side note, the number of financial firms large enough to create ETF product appears to be shrinking. Lehman and Bear Stearns were both APs. I’ll get to the significance of this development on another day

Back to the money.

I’ll assume a best case scenario for the institutional buyer and seller of XLF in the past few weeks. I’ll call that entity “The Trader”. To simplify matters we'll pretend there is no settlement period and that The Trader of these ETF blocks can instantly create or redeem. However, all the numbers I’m using are real.

On September 11th, The Trader buys 29,850,000 XLF shares, or 597 units, for a share price of $21.20, or $632,820,000. The day after XLF shares go up to $21.25, or a nickel higher, The Trader sells the shares, pocketing 29,850,000 shares times 5-cents or $1,492,500. We’ll have to assume he or she arbitraged the risk between the value of the ETF and that of its underlying components.

A million-five gain may seem like a lot of money but we have to put it into context of the $632 million bet. It works out to 0.24% of the total wager. However, if The Trader is able to repeat this exercise every two days for a year they’ll net a 24% return. 

For the past year XLF has had a median discount/premium of 0.28%, which is probably about 5-cents a share.  XLF isn't the only ETF financial play in town. The ProShares Ultra Financial (AMEX: UYG) has also been actively traded.   

There are many uses of ETFs like XLF. Making (or losing) money from the discount/premium is just one possibility.

Whatever the case, whoever is behind the volatile creation and redemptions of shares in XLF is playing billion dollar hands.

Max Rottersman is a partner of Hanover Technology Group, LLC. His opinions don’t necessarily represent the views of ETFguide.com or Yahoo Finance.