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Understanding The True Liquidity of ETFs

Confucius (would have said) “Don’t be afraid to invest in low volume and low AUM ETFs if they add value to your portfolio!"

Introduction

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

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

The ETF creates and redeems to demand. 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. The creation and redemption processes are called the ‘Primary Market’.

Clients buy ETFs on the Exchange in the ‘Secondary Market’ through a broker or member of the Exchange. Constant bid offer spreads are provided by official ‘Market Makers’ (MMs) who are also often APs. The MM has to enter into a binding contract with the relevant Exchange to provide constant bid offer spreads and a minimum size through-out the trading day.

The creation and redemption mechanism facilitates ‘arbitrage’ to keep pricing of the ETF in line with the asset being tracked.

As the number and complexity of ETFs rise it is important investors use the invaluable services of the relevant Issuer’s Capital Markets team to ensure they maximise their execution efficiency.

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

ETF liquidity is a clumsy term. It is often used colloquially to describe on-exchange traded volumes. The ‘true’ liquidity of an ETF is liquidity that is drawn from the underlying market/asset being tracked, not trading 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 assets liquidity. 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.

Parties involved in the ETF liquidity eco-system: 

  • Underlying markets/assets being tracked
  • ETF market makers / APs
  • Custodial banks & stock lenders 
  • Retail investors 
  • Hedge funds, pension funds & institutional clients 
  • Wealth managers and private banks 
  • Governments & central banks 

 

Rather than traded volumes, true ETF liquidity is actually drawn from the underlying assets being tracked. Through the primary market, new ETF units can always be created to meet demand. If there is a liquidity constraint, it is the impact that this process will have on the underlying markets. Given most ETFs only track liquid markets that price continuously during the Exchange trading hours, size constraints are consequently extremely loose.

Evolving Needs of ETF Liquidity

As the ETF market has evolved, so have the liquidity needs and profile of ETFs and their users. The early phase of ETF issuance was mainly replicating the main asset benchmarks e.g. S&P500, DAX, Gold etc. High trading volumes and ultra-tight spreads became the norm and expectation. Many of the new 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 this type of product is a stable bid offer and size relative to the underlying being tracked. Many investors are still learning to adapt to this, but ultimately, 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).

If investors apply outdated and inaccurate perspectives on the importance of ‘traded volume’ & AUM measures to the rapidly proliferating European ETF market, this will stifle growth with no discernible benefit.

Bloomberg has developed a useful tool to help this called ‘Implied liquidity’ where it has a formula on the ETF description page which shows how deep the liquidity is on the underlying is and the largest size before a trade will impact on the underlying market being tracked.

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 24.1m shares or $189,475,000 despite the ETF AUM only being $2.49m. 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 March 1st, 2019.

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 March 1st, 2019. 

Primary Market

Primary market exists to ensure that where a fund needs to increase the issued ETFs 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 sign a comprehensive contract with an ETF issuer that’s 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.

Not all APs will make automated electronic markets on Exchanges - that is usually the domain of specialist trading firms. APs will almost all make over the counter (OTC) markets where their clients will call for quotes, typically in larger size.

APs will instruct the relevant 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 
  • 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 result of multiple aggregate trades and will be the net of them. 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

The on-Exchange market makers are underpinned by the primary market and are ultimately the guarantors of the ability for end investors to be able to buy or sell units freely. 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.

Trading volumes are derived from end investors facilitated by market makers who guarantee that there are always two-way prices in the market. 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 when a natural bid or offer doesn’t exist.

Market makers sign a contract with the Exchange, and in HANetf’s case, with the Issuing company of our ETFs as well. The service level typically tends to be around providing guaranteed bid offer spreads and size and also being 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 investor with the equal and opposite trade exists.

Market makers tend to be specialist trading firms and investment banks. These companies have invested very heavily in automated technology who algorithmically price an ETF dynamically 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

There are multiple ways to trade and buy ETFs. The key 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 are as follows:

  • 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’

  • UK: AJ Bell, Alliance Trust Savings, Ascentric, Charles Stanley Direct, Hargreaves Lansdown,  IG, Interactive Investor, Novia Financial, Pershing, Raymond James Investment Services, Selftrade, Transact
  • Germany: Comdirect, Consorbank, DAB Bank, Ebase, Flatex, ING DIBA, Max Blue, Onvista
  • Italy: Binck, Directa, Fineco, IW Bank, Sella, Webank

 

Download the full whitepaper "Understanding The True Liquidity of ETFs" here.

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