PIZ trades in international markets; IWM trades in small-cap stocks; SPY trades in mid/large cap stocks. Trade ETFs when the underlyings are liquid–avoid trading ETFs at the open or when overall market volume is lackluster. Shares of ETFs are tradable on secondary markets and may trade either at a premium or a … Get comfortable. But this is not the right way to think about it. At each transaction, the market maker has been buying, buying, and buying ETF shares. One way the market maker makes money is by creating a bid/ask spread around the ETFs true tick-by-tick value. The reason the “hedge” transactions are good hedges is because the AP can always create/redeem ETF shares and underlying securities to unwind any positions they have long/short. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future. Regardless, if you attempting a very large transaction, it still makes sense to communicate with the ETF sponsor, so they can keep the market makers informed and ensure an orderly fill without spread impact. Avoid huge market orders, and stick to limit orders. Similar to all publicly traded stocks, the price of ETF shares in the secondary market is determined in real-time based on supply and demand. Looking at the data on the Euro STOXX 50 in Europe, we found that ETFs on the EUROSTOXX 50 represent 2% of the cumulative average daily volume traded. So the market maker buys the ETF from this secondary market participant at $83.75, and in order to hedge, he shorts the basket of names (MSFT and INTC) at $83.80. Market makers help maintain a fair and orderly market by selling ETF shares to potential buyers and by buying ETF shares from potential sellers. Market makers, specifically authorized participants (APs), can arbitrage differences between the net-asset-value (NAV) of an ETF and the value of the underlying ETF holdings. 3. Chris really set the stage for this discussion and answered some burning questions many of you probably had in the back of your mind. When buying or selling ETFs and stocks, you can use a variety of order types, including market orders (an order to buy or sell at the next available price) or limit orders (an order to buy or sell shares at a maximum or minimum price you set). In other words, if an ETF is composed of large liquid stocks, even if its secondary market volumes are very low, the market makers should be able to transact large volumes of the ETF without significant impact on bid/ask spreads. All sounds great up until this point, but we have all been taught the following: Recall that, in these examples, the market makers are managing a market-neutral book. This daily arbitrage mechanism takes a lot of the market-making risk off the table, which gets reflected in the underlying spreads for ETFs that trade liquid underlying securities. This is a real-time price determined by trading activity on the stock exchange. You are investing in a product that tracks an index. So if someone wants to sell the ETF, they will get 24.95, not $25. In the absence of another buyer or seller, a market maker can often match the other side of a pending order. The most visible source of ETF liquidity is the trading activity of buyers and sellers in the secondary market that takes place on an exchange. You are investing in a product that tracks an index. You are investing in a product that tracks an index. SPY is incredibly liquid and the spread is 1 cent, or 1/2 a cent on either side. Affiliated transactions. However, unlike stocks, most bonds are not traded in … At each transaction, the market maker has been buying, buying, BUYING ETF shares. Along with the price discovery benefit, the BoE highlighted the structural benefits of ETFs to have the ability to trade in the secondary market including the immediate liquidity at intra-day prices and the lower risk of a dynamic that leads to the fire sales of underlying assets. The 5 cent difference goes to the market maker. jo.id = 'FJVoiceFeed'; So if someone wants to sell the ETF, they will get 24.95, not $25. The market maker will identify how much it costs to buy and sell the basket for TECH. There are two important corrolaries here for ETF investors. Of course, a big part of the "visible" liquidity in these three different limit books is driven by the popularity and interest in these ETFs. The AP wants to be fully hedged: he is long the basket of names, and short the ETF (but has to deliver it in the future). What is Chris talking about? You'll notice that this mid/large domestic-focused ETF is illiquid at open because the underlying names are illiquid. There are two important corollaries here for ETF investors. If the underlying assets are illiquid, expect the ETF to be illiquid; if the underlying assets are liquid, expect the ETF to be liquid. Market makers are in the business of making markets, which costs money. Past performance is not indicative of future results, which may vary. dedicated to an impact mission of empowering investors through education. Consider an ETF that holds 2 stocks: MSFT and INTC. I have read and agree to the Terms & Privacy Policy. No liquidity, means no love when it comes to buying/selling. This means that an investor can buy MSFT at 47.35 and buy INTC at 36.51. An ETF is simply a basket of securities that are publicly traded in the marketplace. })(); ValueWalk.com is a highly regarded, non-partisan site – the website provides unique coverage on hedge funds, large asset managers, and value investing. The INAV will be based on the prices associated with MSFT and INTC. 15-seconds doesn't sound like a long time, but in the context of intra-day markets, 15-seconds can be an eternity. Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Well, if you notice the 3 limit books from above, they have three different spreads and trade in three different asset classes. And here is the beauty of the ETF structure from the market maker's perspective. Let's go back to the "Secondary Market Sale" example from above. they are traded on stock exchanges. Find a broker that understands how to access the cheapest and most efficient liquidity at the moment in time you need to trade. You’ll also notice that the PIZ book is less liquid than the IWM book, and the IWM book is less liquid than the SPY book. DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot. To buy the underlying in TECH, it would cost 83.86 (47.35+36.51) and to sell the underlying in TECH it would net 83.80 (47.31+36.49). In quadrant 3 (lower left) illiquid underlying assets DO NOT result in a liquid ETF. You are not investing in volume. Because INAV values can have issues, market makers and ETF sponsors maintain a separate, real-time price on their ETF. This has enabled the launch of retail-oriented products like ETFs… Now let's say someone comes along in the secondary market, sees the posted Bid, and wants to sell the ETF at $83.75. One way the market maker makes money is by creating a bid/ask spread around the ETFs true tick-by-tick value. Ask more questions. An ETF's liquidity has everything to do with the underlying liquidity of the positions the ETF holds. The spread is 9 cents, or roughly a 4bps spread on either side. However, 3 minutes later, after the underlyings have settled, the bid/ask tightens to reflect the underlying holdings’ liquidity. (function () { Again there are two great features of ETFs from the market maker's perspective: So let's say the TECH ETF has ZERO shares traded and a limit book that looks like a blank monitor. Get comfortable. 4. The market makers have computers continually monitoring the underlying TECH ETF basket and if investors are buying/selling in the market and they can make an arbitrage profit--they will do so! You are investing in a product that tracks an index. Regardless, if you attempting a very large transaction, it still makes sense to communicate with the ETF sponsor, so they can keep the market makers informed and ensure an orderly fill without spread impact. DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot. If you can efficiently buy and sell the optimal product, other people’s volume is the least of your concerns. Is A “Currency” That Drops 36-percent In A Week Actually Good? We recently had a great interview with Chris Hempstead, a big shot over at KCG, one of the largest ETF market makers in the world. The IWM has a 1 cent spread on either side, or ~1bp. If the underlying assets are illiquid, expect the ETF to be illiquid; if the underlying assets are liquid, expect the ETF to be liquid. Throughout the day, there is an “INAV,” or intra-day net-asset-value, which tracks the value of an ETF on a 15-second basis. Investors often confuse the liquidity of an ETF with the "volume" of shares traded for the ETF. Investors often confuse the liquidity of an ETF with the “volume” in the shares of the ETF. However, when trading an ETF, ZERO shares traded doesn’t really matter. Let’s say the current live net-asset-value based on mid-point prices on TECH is 83.83. Understanding How ETFs Trade in the Secondary Market. For instance, the closing market price of an ETF is the price at which ETF shares were last traded during trading hours. When trading a common stock, this is a major issue. As Chris mentioned, "DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot.". When you're contemplating a basic trade of an ETF, you'll likely look in the secondary market, where most ETF trading takes place. Which means that the ETF shares are equally liquid--even if you don't "see it" as daily trading volume, as you would with ordinary stocks. Answer: daily arbitrage opportunity. The secondary-market price of ETF shares may be more or less than the net asset value (NAV) of the underlying securities. A market maker might post a bid at 24.95 and post an ask of 25.05. Certainly, the liquidity of the underlying assets helps describe the spreads in PIZ, IWM, and SPY observed above. Markets can remain irrational longer than one can remain solvent. Consider the “TECH” ETF that holds 1 share of MSFT and 1 share of INTC. Our mission is to empower investors through education. As he sells the ETF “short” in the secondary market, he will simultaneously go into the market and go long the basket for $83.86, as a hedge. The 5 cent difference goes to the market maker. Which Berkshire Business Would You Sell Off Assuming No Tax Hits? Now let's say someone comes along in the secondary market, sees the posted Bid, and wants to sell the ETF at $83.75. Given this information, the AP will sit back and think, “How do I make a market in TECH?” Being a profit-minded AP, they might set their market prices as follows: Now let’s say someone comes along in the secondary market, sees the posted Ask, and wants to purchase the ETF at $83.91. Note: Bloomberg has a really cool feature called implied liquidity, which allows ETF buyers to better grasp the true liquidity of an ETF.. As money managers have become buyers and sellers of CLOs, trading volume on the secondary market has increased significantly. Let's work through an example so you can understand how these market makers think: Consider the "TECH" ETF that holds 1 share of MSFT and 1 share of INTC. This is essentially "free" for all intents and purposes. This is essentially “free” for all intents and purposes. https://alphaarchitect.com/2014/12/03/trading-etfs-in-the-secondary-market Subscribe to ValueWalk Newsletter. You are not investing in volume. When this happens, what does the market maker do? Similarly, on the buy transaction, an ETF buyer will pay $25.05 for the ETF. But the market maker has been hedging all along by shorting the basket of MSFT and INTC. Find a broker that understands how to access the cheapest and most efficient liquidity at the moment in time you need to trade. We won't send you spam. Are Ben Graham’s Disciples Value and Quality Factor Investors? Let’s say MSFT’s bid/ask is 47.31 by 47.35 and INTC’s bid/ask is 36.49 by 36.51. In return, the ETF sponsor bundles the securities into the ETF wrapper, and delivers the ETF shares to the AP. What happens if it starts to get skewed? ValueWalk also contains archives of famous investors, and features many investor resource pages. On a tick-by-tick basis market makers track the "true" value of an ETF. Similarly, on the buy transaction, an ETF buyer will pay $25.05 for the ETF. Please speak to a licensed financial professional, The Texas Storm: Understood With Peter Kelly-Detwiler, Hoarding Wealth: Seven Deadly Economic Sins, Trading ETFs in the Secondary Market [ANALYSIS], FireEye Tracks Hacker Group ‘FIN4’ that Steals Insider Information, A Look At NFL’s Tax-Exempt Status [INFOGRAPHIC]. DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot. Incredibly liquid. Alpha Architect will use your information to send index updates and for email marketing. Suddenly, the market maker looks up and has a HUGE position in the ETF (although it is hedged). You are not investing in volume. In some ETFs there is a possibility that it becomes so popular, and the secondary market becomes so deep, that an ETF can actually be more liquid than the underlying assets the ETF holds. The AP does not own any ETF shares to sell. Pay attention to the liquidity on the holdings of your ETF–this will explain the spreads in the secondary market. Let’s work through an example so you can understand how these market makers think. Please speak to a licensed financial professional before making any investment decisions. In quadrant 3 (lower left) illiquid underlying assets DO NOT result in a liquid ETF. You are investing in a product that tracks an index. This underlying liquidity matters, because it is the liquidity of the underlying assets that determines how market makers create the "spread." 1. This investor would simply need to communicate with the AP community or the ETF sponsor and let them know that a large limit order is hitting the market. Not all of an ETF's liquidity in … She directs a 150-person team that helps the firm direct the $160 billion of assets it manages Read More. Dr. Gray currently resides in the suburbs of Philadelphia with his wife and three children. As he sells the ETF "short" in the secondary market, he will simultaneously go into the market and go long the basket for $83.86, as a hedge. They don't require secondary market volume to unwind the hedged book -- the market maker can simply redeem an ETF unit, and simultaneously cover his shorted basket of MSFT and INTC. Once again, this can occur regardless of the ETF’s market volume. Chris’ final words: This year's Sohn 2021 Investment Conference featured Patrick O'Shaughnessy in conversation with Karen Karniol-Tambour. And while popularity and interest certainly contribute to liquidity, the real driver of liquidity in an ETF is the liquidity of the underlying assets that the ETF holds. Here are some example limit books from 11/26 (~9:35am) on PIZ, IWM and SPY. For example, let's say the value of the underlying basket of stocks in an ETF is worth $25. The focus for today is understanding how markets are made in ETFs. Go forth and compound! (Note: the $24.95 is the last trade). When this happens, what does the market maker do? The spreads on these three ETFs seem to match up with the liquidity of the stocks they contain. The INAV will be based on the prices associated with MSFT and INTC. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. The market maker will identify how much it costs to buy and sell the basket for TECH. An educated investor can defend against the financial services industry, which is a marketing juggernaut, and doesn't always have your best interest in mind. Currency ETFs – these are invested in a single currency or a basket of various currencies and are widely used by investors who wish to gain exposure to the foreign exchange market without directly trading futures or the forex market. But if they are aware of a large order, the APs know full well they can make profits by selling the TECH ETF @ 83.91, while buying and holding the basket/covering their shorts of MSFT and INTC, and thus they will sell as much TECH ETF as any secondary market participant can handle at 83.91, up until their buying pressure in the underlying MSFT and INTC starts having an impact on the actual underlying securities (in other words, it would probably require a lot bigger order than a $1,000,000 order). Wes has published multiple academic papers and four books, including. First, the opening limit book on an ETF @ 9:30am with a fair value estimate is 25.32--huge spreads (23.78 x 26.82): Next, the same limit book 3 minutes later @ 9:33am with a fair value estimate of 25.308--tighter spreads (25.25 x 25.36): Trade ETFs like you would trade the underlying stocks in an ETF. Several factors influence an ETF’s price in the secondary market, including the share-price movement of the underlying securities, currency exchange-rate movements (for international investments) and investors’ demand for the ETF. The reason why the liquidity of the underlying assets is so important to ETF liquidity has to do with how the market makers make a profit, which we'll get to in a minute. jo.type = 'text/javascript'; The focus for today is understanding how markets are made in ETFs. Because INAV values can have issues, market makers and ETF sponsors maintain a separate, real-time price on their ETF. We respect your privacy. Unfortunately, INAVs are not always 100% accurate, and by design, they can be up to 15-seconds delayed. Breaking down volumes based on market movements furthers the notion of secondary market ETF trading providing additive liquidity benefits during periods of market stress. Pay attention to the liquidity on the holdings of your ETF--this will explain the spreads in the secondary market. All sounds great up until this point, but we have all been taught the following: Recall that, in these examples, the market makers are managing a market-neutral book. The spreads on these three ETFs seem to match up with the liquidity of the stocks they contain. Here are some example limit books from 11/26 (~9:35am) on PIZ, IWM and SPY. To the extent ETF holders all demand liquidity at the same time, and the liquidity of the ETF reverts to the underlying liquidity, there is a chance investors endure some pain. When demand increases, more ETF shares can be created using this process. You are not investing in volume. What matters is how liquid the underlying shares are that make up the ETF. Consider the TECH ETF. An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product, i.e. 15-seconds doesn’t sound like a long time, but in the context of intra-day markets, 15-seconds can be an eternity. The INAV will be based on the prices associated with MSFT and INTC. The IWM has a 1 cent spread on either side, or ~1bp. If you can efficiently buy and sell the optimal product, other people’s volume is the least of your concerns. If they are “surprised” they may think an arbitrageur is trying to get the best of them, and that perhaps something is wrong with a stock in the basket or with their own internal NAV calculations of which they are not yet aware, and reflexively widen the spread. Our mission is to empower investors through education. The Bottom Line Like stocks, after issuance in the primary market, bonds are traded between investors in the secondary market. Let's say MSFT's bid/ask is 47.31 by 47.35 and INTC's bid/ask is 36.49 by 36.51. But the market maker has been hedging all along by shorting the basket of MSFT and INTC. This daily arbitrage mechanism takes a lot of the market-making risk off the table, which gets reflected in the underlying spreads for ETFs that trade liquid underlying securities. Pretty liquid. Throughout the day, there is an “INAV,” or intra-day net-asset-value, which tracks the value of an ETF on a 15-second basis. The buyer will get an asset worth $25, and the 5 cent premium will go to the market maker for making a market in the ETF. Ask questions. As Chris mentioned, “DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot.”. As … Being a profit-minded AP, they might set their market prices as follows: Now let's say someone comes along in the secondary market, sees the posted Ask, and wants to purchase the ETF at $83.91. So what about this hedged book the market maker is holding? You’ll notice that this mid/large domestic-focused ETF is illiquid at open because the underlying names are illiquid. Chris is correct. Here is a live example from Friday, November 28th, the day after Thanksgiving when the markets are not very active. Why are market makers content with the arrangement knowing full well that market neutral books can get out of wack in the short run? Costs of Trading. Let's say the current live net-asset-value based on mid-point prices on TECH is 83.83. You are not investing in volume. var r = Math.floor(Math.random() * (9999 - 0 + 1) + 0); Better trading and execution will lead to better returns and happier investments. Bond Ladders and Income Annuities: Simple is Beautiful. Throughout the day, there is an "INAV," or intra-day net-asset-value, which tracks the value of an ETF on a 15-second basis. In reverse, if an ETF is traded at a discount to its NAV (e.g. var jo = document.createElement('script'); As stated earlier, ETFs, like stocks, are trading on the secondary market. Secondary market liquidity is determined primarily by the volume of ETF shares traded. This investor would simply need to communicate with the AP community or the ETF sponsor and let them know that a large limit order is hitting the market. As it turns out, market making for ETFs differs in some fundamental ways from the type of market making associated with other listed securities. On a tick-by-tick basis market makers track the “true” value of an ETF. There you'll need to first find the quoted price and the number of shares available at that quote. The AP is “short,” in the sense that he will at some point in the future (within 6 days) need to deliver these ETF shares to the buyer. If a large investor wants to put in an order to buy $1,000,000 worth at 83.91, they can get filled with little market impact–if they go about the process correctly–and let’s not even consider the “primary” market, let’s stick to secondary trading. Most noninstitutional investors transact in the secondary market—which means investors are trading the ETF shares that currently exist. We recently had a great interview with Chris Hempstead, a big shot over at KCG, one of the largest ETF market makers in the world. These exchange-traded funds usually track the most popular international currencies such as the U.S. dollar, Canadian dollar, Euro, British pound, and Japanese yen. As shown below, breaking out volumes by daily price returns for the S&P 500 illustrates a volume smile trend — with higher volumes on both above and below +/-1% days (i.e., the big up and down days in 2020). Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). This will prevent the APs from being “surprised” by a huge order. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. This underlying liquidity matters, because it is the liquidity of the underlying assets that determines how market makers create the “spread,” and in a profitable way that ensures their own ongoing solvency. Again there are two great features of ETFs from the market maker’s perspective: So let’s say the TECH ETF has ZERO shares traded and a limit book that looks like a blank monitor. And while popularity and interest certainly contribute to liquidity because there is a large and robust secondary market (i.e., ETF holders are trading amongst each other), the fundamental driver of liquidity for most ETFs is the liquidity of the underlying assets that the ETF holds. This also implies that an investor can sell MSFT at 47.31 and sell INTC at 36.49. PIZ trades in international markets; IWM trades in small-cap stocks; SPY trades in mid/large cap stocks. This also implies that an investor can sell MSFT at 47.31 and sell INTC at 36.49. Given this information, the AP will sit back and think, "How do I make a market in TECH?" However, 3 minutes later, after the underlyings have settled, the bid/ask tightens to reflect the underlying holdings' liquidity. How Portfolio Construction Impacts the Reliability of Outcomes, Democratize Quant Conference Recap and Materials, A Short Research Library Outlining Why Traditional Stock Picking is Challenging, ETF-prenuers: An Introduction to ETF White Label Services, Free Tool Announcement: Visualizing Unemployment Claims. And here is the beauty of the ETF structure from the market maker’s perspective. Trade ETFs when the underlyings are liquid--avoid trading ETFs at the open or when overall market volume is lackluster. They compare these two "theoretical" portfolios to the live net asset value of the ETF. Q1 2021 hedge fund letters, conferences and more Karen Karniol-Tambour is the head of investment research at Bridgewater Associates, the world's largest hedge fund. Market makers don't track the tick-by-tick value of an ETF for their health--they do it so they can make money! Find a broker that understands how to access the cheapest and most efficient liquidity at the moment in time you need to trade. The buyer will get an asset worth $25, and the 5 cent premium will go to the market maker for making a market in the ETF. If they are "surprised" they may think an arbitrageur is trying to get the best of them, and that perhaps something is wrong with a stock in the basket or with their own internal NAV calculations of which they are not yet aware, and reflexively widen the spread. For example, high yield debt. Market makers are in the business of making markets, which costs money. What makes ETFs unique is the AP’s ability to arbitrage the spread between underlying assets and the ETF NAV at the end of every trading day. Consider an ETF that holds 2 stocks: MSFT and INTC. In quadrant 4 (lower right) liquid underlying assets DO NOT result in an illiquid ETF. You'll also notice that the PIZ book is less liquid than the IWM book, and the IWM book is less liquid than the SPY book. With ETFs, the end investors trade shares on a secondary market that matches buyers and sellers. Both mechanisms restore the ETF back to fair value providing more efficient trading in the secondary market. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. So the market maker buys the ETF from this secondary market … Consider an ETF that holds 2 stocks: MSFT and INTC. Moreover, for huge trades, communicate directly with the market maker or your ETF trading desk. This has a few implications: Also, a special note on trading ETFs at the open. DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot. These newly created ETF shares are then introduced to the secondary market, where they are traded between buyers and sellers through the exchange. Ask questions. This intuition underlying this concept is set forth in the chart below, which has four quadrants. To assess secondary market liquidity, follow an ETF at different times of day, over various time periods, and note how it’s affected by market environments. Are Ben Graham’s Disciples Value and Quality Factor Investors? Unfortunately, INAVs are not always 100% accurate, and by design, they can be up to 15-seconds delayed. In the secondary market, firms that specialize in buying and selling ETF shares—APs or market makers2 (liquidity providers) —trade them to provide market liquidity and make a profit. The spread is set such that it is profitable for the market maker. document.getElementsByTagName('head')[0].appendChild(jo); A market maker might post a bid at 24.95 and post an ask of 25.05. An ETF’s liquidity has everything to do with the underlying liquidity of the positions the ETF holds. ETF share in secondary market trading We can also calculate the ETF footprint on the secondary market (i.e. They don’t require secondary market volume to unwind the hedged book – the market maker can simply redeem an ETF unit, and simultaneously cover his shorted basket of MSFT and INTC. - alphaarchitect.com/?p=61695. However, as a market maker, he can effectively create new shares by “selling short” a TECH share to this secondary market participant for $83.91. Let’s say that secondary market participants relentlessly hit the market maker’s Bid at $83.75. Sure, it has ZERO shares traded, but the underlying assets that TECH holds are extraordinary liquid (MSFT and INTC). Unsubscribe at any time. This statistic presents the value of exchange traded funds (ETFs) traded on the Euronext stock exchange secondary market from 2004 to 2020. Chris is correct. After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. When trading a common stock, this is a major issue. In order to see how you might expect things to get skewed, let’s go back to the “Secondary Market Sale” example from above. Note how in quadrant 1 (upper left), illiquid underlying assets result in an illiquid ETF, and in quadrant 2 (upper right) liquid underlying assets result in a liquid ETF.
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