There are three intricacies in running an ETF that I come up with: coping with the cash or cash-like instrument; usage of global futures and security lending; and dealing with corporate actions.
Cash exists because of redemption needs, fees, and expenses. Some stock components dispense dividends regularly, accounting for cash in portfolios too. In calculating index returns, however, the dividends are deemed received and reinvested on the ex-date. However, in the real world, there is a gap between declared date and pay date. So the fund managers often use derivative products like futures to receive equity returns on the
cash and cash accruals that cannot be immediately invested in securities. It’s quite a delicate artwork of fund manager to determine the balance of picking future contracts with a short maturity versus the cost and fee associated with rolling these short-termed futures forward.
Since ETF managers are constantly performing ETF unit creation and redemption, they hold a large number of securities. In big ETF issuer firms such as BlackRock or Vanguard, they usually have a separate team dedicated to security lending business, and fund managers would be working closely with that team to not only facilitate the lending business but effectively enhance performance. Due to tax treatment, the proper utilization of security lending brings in added returns for investors, particularly by international equity securities lending.
With regard to corporate actions, which is occurring constantly, inevitably impacting the components of an ETF with mainly three scenarios: acquirer is constituent, the target is constituent, or both are constituents. The transaction can be realized via cash or stock exchanges.
Those top index providers such as MSCI, S&P, FTSE all have their own rules to deal with the addition/deletion as well as the index value calculation in the event of corporate actions. For the purpose of a tight tracking error(TE) in running an ETF benchmarked against that index, the fund managers need to be not only fully aware of these rules but also apply their corresponding methodologies in real trading.
Taking the non-priced stocks as an example, the following table shows the variation of treatments offered by the top indexers, bearing in mind the real world events are much more complex.
According to STOXX (growing up big as a major index provider especially in the European market nowadays) ‘s principle: