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How investors can benefit from another ETF 'heartbeat trade'

By working with Capital Markets specialists, investors can trade in and out of ETFs more efficiently than they may realise.

A quirk of exchange-traded fund (ETF) trading known as the 'heartbeat trade' has attracted a lot of attention recently.

Essentially a function of US tax law and the creation/redemption process with authorised participants, who play a vital intermediary role between investors and ETF providers, heartbeat trades allow ETFs to use their inflows and outflows to manage capital-gains liabilities. This is less relevant for European investors, but there are other ways in which authorised participants can make ETF trading more efficient through the heartbeat of creation and redemption flows. 

A recent example illustrates this point perfectly. A client wanted to move a large investment from one equity ETF into another that tracked a similar basket of stocks. The intuitive process for doing so would simply have been to liquidate the position in the first ETF and then use the proceeds to buy the second, which would require two separate transactions. The indicative cost of selling the first ETF was 9 basis points, as was the indicative cost of buying the second, so the expected total cost of switching between the two would have been 18 basis points.

That intuitive 'sell then buy' approach was not the most efficient way of making the trade, however. We were able to analyse the underlying basket of stocks for each ETF on the client's behalf, and discovered that there was an 88% overlap between the securities. This meant that the client could use a single authorised participant's services to complete the switch for them without incurring two separate sets of full transaction costs. 

In brief, the ETF creation/redemption mechanism allows the investor to redeem their shares in the fund being sold through the authorised participant. The authorised participant takes these shares and exchanges them with the ETF provider for the basket of underlying stocks.

AP style

Because the stocks in this case were 88% identical to those held by the ETF to be bought, the authorised participant didn't need to turn over the entire portfolio. Rather, the authorised participant just had to add the new stocks to match the index of the ETF being purchased and sell the minority no longer required; this updated basket of stocks could then be exchanged with the new ETF provider for shares in the fund.

In this case, for instance, we approached three different authorised participants on the client's behalf to preserve their anonymity. The most competitive quote was 6 basis points for selling the old ETF and 7 basis points for buying the new one, for a total indicative transaction cost of 13 basis points. Compared with the indicative roundtrip cost of 18 basis points for the two-stage transaction, our client was thus able to save 5 basis points – equivalent to a year's worth of expenses for some ETFs.

As well as demonstrating the value of working with a dedicated capital-markets specialist and authorised participants, this further emphasises the importance of focusing on an ETF's total cost of ownership rather than just its headline total expense ratio.