Hedging Your ETF Bets

When regulatory agencies put limits on trading securities that ETFs track, the entire pricing mechanism is thrown for a loop.

Proposed regulations affecting futures-based commodity and leveraged ETFs could change the industry, and Goldman Sachs ( GS) has been the first to speak out.

"Consumers need hedging. Producers need hedging. And you need financial intermediaries to help do that," Goldman's Chief Financial Official David Viniar noted on the recent earnings conference call.

While regulations may not be imminent for the markets as a whole, ETF investors should understand the ways in which regulatory action has already affected ETF trading.

Every ETF has an underlying net asset value (NAV) that the fund is supposed to track. The process of ETF creation helps keep share price in line with NAV during the trading day. ETF market makers create units of shares, usually in 50,000 or 100,000 share lots, to meet customer demand for funds. When investors buy shares from a designated market maker (a sort of ETF specialist), the market maker will in turn hedge his or her position to minimize risk.

How Creation and Hedging Work

As a basic example, imagine an ETF made up of just AT&T ( T), Verizon ( VZ) and Sprint ( S). Let's call it the U.S. Cell Phone Fund (UCF).

For the sake of simplicity, this fund will have a 50,000 share unit. On day one of trading, you create 50,000 shares. To create these shares, you have to deliver to an intermediary bank) the shares required plus any additional cash or cash equivalents. In essence, you get 50,000 shares of the fund in return for everything that is in the underlying basket.

If UCF contains 50% AT&T, 30% Verizon and 20% Sprint, you will have to deliver 25,000 shares of AT&T, 15,000 shares of Verizon and 10,000 shares of Sprint to get one unit of UCF. Before trading on the first day, you will be 100% hedged. As a designated market maker, as soon as trading begins you will have to be willing to both buy and sell the ETF during the course of the trading day.

Let's say that UCF immediately is a hit. Right after the opening on day one of trading, an order comes in for 5,000 shares. Instead of selling it to the buyer at NAV, you sell it 2 cents above. Why is this fair? Because until you can re-hedge, you are no longer 100% hedged like you were before trading.

If you liked this article you might like

ProShares UltraShort Financials Getting Very Oversold

Jim Cramer's 'Mad Money' Recap: Stock Market Survival School

Jim Cramer's 'Mad Money' Recap: Stock Market Survival School

Cramer's 'Mad Money' Recap: Stock Market Survival School

Cramer's 'Mad Money' Recap: Stock Market Survival School