Understanding The True Liquidity of ETFs

Introduction

Exchange Traded Funds (ETFs) are open ended mutual funds that are listed and trade on regulated stock exchanges, such as London Stock Exchange, NYSE and Deutsche Boerse.

From an investors’ perspective, ETF liquidity is primarily about ensuring that real-time two-way markets are always available when an investor wants to buy or sell an ETF. This situation is normal business in most market conditions during the Exchange trading day hours and is one of the major advantages which ETFs have over traditional mutual funds that are traded only once a day.

Liquidity in ETFs is often misunderstood. This article seeks to explain how the true liquidity of ETFs is deeper than imagined, and formed through a combination of the underlying asset class and primary and secondary market trading activity

The primary market of an ETF is the mechanism of creating or redeeming ETF units through buying and selling the underlying shares or securities. The only parties who can do this are called ‘Authorised Participants’ (APs). APs are usually large financial institutions such as Investment Banks and professional trading firms who are experts in the asset classes in which they participate. The creation and redemption mechanism facilitates ‘arbitrage’ to keep pricing of the ETF in line with the asset being tracked.

End investors buy and sell ETFs on the Exchange in the ‘Secondary Market’, through a broker or member of the Exchange. Constant bids and offers (buy and sell prices) are provided by official ‘Market Makers’ (MMs)

ETF Liquidity - Trading Volumes, AUM or underlying Being Tracked?

ETF liquidity is a term often used colloquially to describe on-exchange traded volumes, but this is a mistake. The ‘true’ liquidity of an ETF is liquidity is that which is drawn from the underlying market or asset being tracked - not on-exchnage volumes. Given most of the underlying assets tracked by ETFs are highly liquid, most ETFs can draw tens to hundreds of USD millions without having a negative impact on the underlying market. This is ultimately the same whether an ETF has a small amount of investment in it (AUM) or it doesn’t have significant daily trading volumes.

For example, not all FTSE 100 ETFs trade the same amount on exchange, but they all have the same underlying liquidity – the liquidity of the 100 stocks in the index which can be bought or sold by the AP. Similarly, not all physical gold ETPs will show the same amount of on exchange volume, but they all share the same underlying liquidity of the global gold markets.   

True ETF liquidity is actually drawn from the underlying assets being tracked.

Through the primary market, new ETF units can be created to meet demand. If there is a liquidity constraint in an ETF is reflective of underlying constraints at the asset class level. Given most ETFs only track liquid markets that price continuously during the Exchange trading hours, size constraints are consequently extremely loose.

Parties involved in the ETF liquidity eco-system:

• Underlying markets/assets being tracked: Most liquid securities and asset classes can be tracked by ETFs. Includes global equities, government and corporate bonds, commodities, derivatives, MLPs and many others.
• Exchanges: Where ETFs are listed, bought and sold. Exchanges provide regulated and orderly marketplaces.
• Authorised Participants: The primary market – create and redeem ETF shares to match demand from investors.
• Market Makers: The secondary market – buy and sell ETF shares on the stock exchange on behalf of end investors.
•  Platforms: Share trading, brokerage, banking and retail platforms that enable end investors to buy and sell ETFs.
• Investors: ETFs are highly democratic products and appeal to many investor types from central banks, pension and insurance funds to charities, endowments, hedge funds, wealth managers, private banks and individual investors. 

How ETF Liquidity Is Evolving

As the ETF market has evolved, so have the liquidity needs and profiles of ETFs and their users.

The early phase of ETF issuance was mainly replicating the main benchmarks e.g. S&P 500, DAX, Gold etc. High trading volumes and ultra-tight spreads became the norm and the expectation. The second phase of ETFs, such as smart beta, thematic and active ETFs, are ‘buy and hold’ or ‘investment’ type products where traded volume becomes much less of a focus. The liquidity needs for the 2.0 type of product is a stable bid offer and size relative to the underlying being tracked.

This change in perspective regarding ETF liquidity is going to be very important to allow investors to enter new, exciting, innovative ETFs at their launch with lower assets under management (AUM).

Bloomberg has developed a useful tool called ‘Implied liquidity’ - A formula on the ETF description page shows depth of liquidity in the underlying market and the largest tradable before there’s impact on the underlying market.

An example below is the HAN-GINS Cloud Technology ETF (SKYY LN), listed at the end of 2018. The section highlighted in red shows implied liquidity of 17.4m shares or $164,979,000m despite the ETF AUM only being  $24.16m.. You can type ETFL <GO> and you will be taken to the calculation page to see where the numbers come from.

Source: Bloomberg, as of May 21st, 2020.

The next Bloomberg screen print shows that the new ETF’s trading is still thin in its early life.

Source: Bloomberg, as of March 1st, 2019.

The next screen shows a sub section of the underlying equities included in the ETF that clearly shows the daily liquidity off the underlying basket is significantly higher than the ETF. This gives assurance to the buyer they can do large trades without materially impacting the price of the ETF. Essentially ETFs are a ‘pass through’ vehicle. The implied liquidity function essentially describes the ‘true liquidity’ of the ETF and provides some comfort to the end investor as to the level of trade they can ordinarily execute no matter what the trading volumes or AUM of the ETF is.

 Source: Bloomberg, as of May 28th 2020

Primary Market

The primary market exists to ensure that when a fund needs to increase the issued ETF shares it can do so (creations) and where supply exceeds demand ETFs can be cancelled (redeemed). This all happens invisibly to the end investor to ensure that the ETF secondary market operates without interruption. APs will almost all make over the counter (OTC) markets where their clients will call for quotes, typically in larger size.

APs sign a comprehensive contract with an ETF issuer that gives them the right to be able to create and redeem the ETF units. APs are typically large financial institutions such as investment banks and specialist trading firms.

APs will instruct the ETF issuer they want to either:

Create new ETF units where they have a short ETF position due to the fact that they have sold more of the ETF than they own OR

Redeem existing ETF units where they have a long position due to the fact they have bought from a client and want to reduce the inventory they hold

The ETF primary market allows the ETF issuer to ensure that investors can buy and sell ETFs to demand. If there isn’t enough of a ETF in issue, an AP can sell the ETF in advance of owning it but then create end of day to match the settlement of the initial trade and settle both at the same time.

Most of the time, a creation or redemption will be the net result of multiple aggregate trades. This is a significant advantage over an unlisted mutual fund where creates and redeems are the gross orders adding more friction to the fund. These attritional costs ultimately get passed onto legacy unit holders and not the new (creates) or old (redeems) investors.

Another benefit is the responsibility for the trading of the create basket is passed to the AP/MM - unlike a mutual fund where it’s the internal dealing desk. Any mistakes in the latter are passed onto the legacy unit holders unlike ETFs where that risk sits with the AP/MM.

ETF Issuers have multiple APs and MMs. Please find a full list of the companies supporting HANetf funds here. 

Secondary Market

Underpinned by the primary market, the on-Exchange Market Makers (specialist trading firms and investment banks) are guarantors of the ability for end investors to be able to buy or sell units freely.

Market makers sign a contract with the Exchange (and in HANetf’s case, with the Issuing company of our ETFs as well) guaranteeing that there are always two-way prices in the market and size. Market Makers must also be technically robust to ensure that downtimes, where no prices are available, are minimised. The result is the end investor can expect a bid and offer of last resort if no natural opposite trade exists.

Typically markets tend to be skewed one way (more buyers than seller, or vice versa) and market makers ensure there is always a bid or an offer even when a natural buyer or seller doesn’t exist. They do this by being long or short the ETF, as they buy and sell to demand and are conversely hedged. When their position gets large enough due to secondary market trades, they put in a create or redeem order to the issuer and close out their hedge to flatten their exposures and deliver or receive the ETFs from the market.

APs and Market Makers have invested very heavily in automated technology and dynamic, algorithmic pricing of ETFs based on the underlying asset being tracked. Pricing is kept accurate and in line by the inherent arbitrage between the ETF and underlying asset. Effectively any mis-pricing will be brought back in line by a second party arbitraging the first who mispriced. The second party then can realise the arbitrage by creating or redeeming in the primary market or buying and selling the ETF in the secondary markets. 

ETF Issuers have multiple APs and MMs. Please find a full list of the companies supporting HANetf funds here.

Execution Options & Order Types

ETFs are designed to be flexible, and there are many ways to trade them. The key is to efficient execution is to discuss your needs with the issuers’ capital markets team to make a better-informed decision, especially where the trade is large.

However, the most well used types of execution include:

• Risk / Single Point Execution - ETF is executed at a single point in time, normally trading against a market maker in a block
• Limit / Iceberg - ETF is executed at a limit price either as a single fill (total volume) or by displaying a smaller portion of the volume and reloading more volume as parts of the total order are executed
• In line With Volume - ETF is executed at a limit price either as a single fill (total volume) or by displaying a smaller portion of the volume and reloading more volume as parts of the total order are executed
• MOC - ETF is executed at the closing price of the on-exchange ETF listing
• NAV - ETF is executed relative to the Net Asset Value of the ETF (normally based off the closing level of the underlying asset)
• VWAP / TWAP / Over the Day - The ETF execution is spread out over the day or over a period, and is executed in smaller incremental child orders
• Pair Trade / Relative - ETF is executed relative to a dynamic (or moving) benchmark (either another ETF, a future, or a live index)

Simple Guidelines for Efficient ETF Execution

In approaching an ETF execution follow simple rules to devise the optimal execution strategy

• Focus on the spread of the ETF and its spread relative to the expected underlying spread
• Focus on the implied liquidity of the ETF (from its underlying) as opposed to the actual liquidity of the ETF itself
• Try to execute when the underlying is open (or most of the underlying)
• Avoid the exchange open or periods of economic data releases e.g. payroll numbers release
• Utilize SI’s (Systematic Internalizes) either through algorithms or through marketable limit orders
• If possible, reduce pin risk by spreading your execution over the day
• Use order types such as limit orders when appropriate
• REMEMBER TO EXPLORE A RANGE OF STRATEGIES (DON’T JUST STICK TO ONE!)

Liquidity Risks in ETFs

Because the combination of primary, secondary and derivative markets provides the underlying liquidity to ETFs, if there is an issue in the liquidity of the underlying asset class then this will be reflected in the ETF (and any other investment products that are exposed to that asset class) and may have a negative impact. Liquidity risk, as well as other risks associated with the specific ETF exposure will be detailed in the Key Investor Information Document KIID which is publicly available on ETF issuer websites.

Capital Markets Team

The HANetf Capital Markets function has been set up to help investors efficiently execute their ETF trades. Our staff have over 25 years of ETF execution experience and are very happy to consult end investors on efficient execution. We can also help advise on times of day to trade if relevant and also advise on the most qualified APs and MMs for each ETF and asset class.

Contact HANetf Capital Markets - Jason Griffin, Director of Capital Markets & Business Development | [email protected]

Trading HAN ETFs

Our ETFs are available to buy and sell on a variety of platforms. The following list in non-exhaustive. For full details, visit www.hanetf.com/partners and select ‘Execution Platforms’