Understanding The True Liquidity of ETFs
(would have said) “Don’t be afraid to invest in low volume and low AUM ETFs if
they add value to your portfolio!"
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
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 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
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
ETF Issuers have multiple APs and MMs.
Please find a full list of the companies supporting HANetf funds here.
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
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.
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
- 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
- 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
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
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
- 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,
Download the full whitepaper "Understanding The True Liquidity of ETFs" here.