Well, if you notice the 3 limit books from above, they have three different spreads and trade in three different asset classes. 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. DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot. var jo = document.createElement('script'); 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. 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. A market maker might post a bid at 24.95 and post an ask of 25.05. Well, if you notice the 3 limit books from above, they have three different spreads and trade in three different asset classes. 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. Get comfortable. 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! 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. They compare these two "theoretical" portfolios to the live net asset value of the ETF. Ask more questions. An ETF is simply a basket of securities that are publicly traded in the marketplace. Now let's say someone comes along in the secondary market, sees the posted Bid, and wants to sell the ETF at $83.75. I have read and agree to the Terms & Privacy Policy. You are investing in a product that tracks an index. Secondary liquidity is … But this is not the right way to think about it. 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. Chris is correct. PIZ trades in international markets; IWM trades in small-cap stocks; SPY trades in mid/large cap stocks. Consider the “TECH” ETF that holds 1 share of MSFT and 1 share of INTC. 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. Dr. Gray currently resides in the suburbs of Philadelphia with his wife and three children. But this is not the right way to think about it. When trading a common stock, this is a major issue. But the market maker has been hedging all along by shorting the basket of MSFT and INTC. Unfortunately, INAVs are not always 100% accurate, and by design, they can be up to 15-seconds delayed. supply is higher than demand), APs can short-sell the underlying securities, buy ETF shares on the secondary market and then redeem ETF shares with the issuer. In order to see how you might expect things to get skewed, let’s go back to the “Secondary Market Sale” example from above. 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. Let’s work through an example so you can understand how these market makers think. For instance, the closing market price of an ETF is the price at which ETF shares were last traded during trading hours. There are two important corollaries here for ETF investors. Market price is the trading price of an ETF share in the secondary market (i.e. Suddenly, the market maker looks up and has a HUGE position in the ETF (although it is hedged). Chris’ final words: This year's Sohn 2021 Investment Conference featured Patrick O'Shaughnessy in conversation with Karen Karniol-Tambour. In general, international stocks (PIZ) are less liquid than Russell 2000 stocks (IWM), and US small-caps (IWM) are less liquid than S&P 500 stocks (SPY). 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. Why are market makers content with the arrangement knowing full well that market neutral books can get out of wack in the short run? What matters is how liquid the underlying shares are that make up the ETF. 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. (function () { With ETFs, the end investors trade shares on a secondary market that matches buyers and sellers. You'll notice that this mid/large domestic-focused ETF is illiquid at open because the underlying names are illiquid. However, unlike stocks, most bonds are not traded in … 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. You are not investing in volume. 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 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. The secondary-market price of ETF shares may be more or less than the net asset value (NAV) of the underlying securities. Now let's say someone comes along in the secondary market, sees the posted Bid, and wants to sell the ETF at $83.75. var r = Math.floor(Math.random() * (9999 - 0 + 1) + 0); Not all of an ETF's liquidity in … Similarly, on the buy transaction, an ETF buyer will pay $25.05 for the ETF. Get comfortable. Consider the TECH ETF. Pretty liquid. 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. However, 3 minutes later, after the underlyings have settled, the bid/ask tightens to reflect the underlying holdings’ liquidity. However, when trading an ETF, ZERO shares traded doesn’t really matter. Mission: Providing a framework to improve your investing PROCESS, while collecting newsworthy information about trends in business, politics and tech areas. Understanding How ETFs Trade in the Secondary Market. Unsubscribe at any time. The Bottom Line Like stocks, after issuance in the primary market, bonds are traded between investors in the secondary market. This has a few implications: Also, a special note on trading ETFs at the open. As it turns out, market making for ETFs differs in some fundamental ways from the type of market making associated with other listed securities. Let’s say the current live net-asset-value based on mid-point prices on TECH is 83.83. Sure, it has ZERO shares traded, but the underlying assets that TECH holds are extraordinary liquid (MSFT and INTC). On a tick-by-tick basis market makers track the “true” value of an 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. You are not investing in volume. The focus for today is understanding how markets are made in ETFs. Moreover, for huge trades, communicate directly with the market maker or your ETF trading desk. When demand increases, more ETF shares can be created using this process. These newly created ETF shares are then introduced to the secondary market, where they are traded between buyers and sellers through the exchange. For example, let’s say the value of the underlying basket of stocks in an ETF is worth $25. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future. This profit margin is embedded in the bid/ask spread, which reflects the implicit costs of trading ETFs. 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. When this happens, what does the market maker do? Investors often confuse the liquidity of an ETF with the "volume" of shares traded for the ETF. Chris is correct. What matters is how liquid the underlying shares are that make up the ETF. He has made the market, is fully hedged, and has made a small spread in the transaction. 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. Chris really set the stage for this discussion and answered some burning questions many of you probably had in the back of your mind. 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.". Avoid huge market orders, and stick to limit orders. You are not investing in volume. Trade ETFs when the underlyings are liquid--avoid trading ETFs at the open or when overall market volume is lackluster. Better trading and execution will lead to better returns and happier investments. Costs of Trading. This means that an investor can buy MSFT at 47.35 and buy INTC at 36.51. Because INAV values can have issues, market makers and ETF sponsors maintain a separate, real-time price on their ETF. So what about this hedged book the market maker is holding? The natural liquidity of ETFs trading in the secondary market is enhanced by exchange-registered traders called market makers. Affiliated transactions. The firms establishing these quotes are ETF market makers—the whiskey of Bill's example. 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. At each transaction, the market maker has been buying, buying, and buying ETF shares. Sohn 2021 Investment Conference: Bridgewater Is Concerned About Inflation And Fiscal Policy, If you are interested in contributing to ValueWalk on a regular or one time basis - email us at info(at)valuewalk.com. Market makers help maintain a fair and orderly market by selling ETF shares to potential buyers and by buying ETF shares from potential sellers. 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. You are investing in a product that tracks an index. For example, let's say the value of the underlying basket of stocks in an ETF is worth $25. Though stocks are one of the most commonly traded securities, there are also other types of secondary markets. Now let's say someone comes along in the secondary market, sees the posted Bid, and wants to sell the ETF at $83.75. (Note: the $24.95 is the last trade). The INAV will be based on the prices associated with MSFT and INTC. The AP does not own any ETF shares to sell. 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. You are not investing in volume. Once again, this can occur regardless of the ETF's market volume. For very large, very liquid ETFs that trade at the same time as their underlying securities, like Vanguard S&P 500 ETF , market orders will likely result in fast execution at a good price. Our mission is to empower investors through education. Sure, it has ZERO shares traded, but the underlying assets that TECH holds are extraordinary liquid (MSFT and INTC). Pretty liquid. 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. An ETF's liquidity has everything to do with the underlying liquidity of the positions the ETF holds. Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Moreover, for huge trades, communicate directly with the market maker or your ETF trading desk. 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. However, 3 minutes later, after the underlyings have settled, the bid/ask tightens to reflect the underlying holdings' liquidity. 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'; Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Pay attention to the liquidity on the holdings of your ETF–this will explain the spreads in the secondary market. Someone has to buy the computers, pay the employees, and pay the rent to keep the lights on at the market making shop. There you'll need to first find the quoted price and the number of shares available at that quote. This has a few implications: Also, a special note on trading ETFs at the open. What happens if it starts to get skewed? 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 the absence of another buyer or seller, a market maker can often match the other side of a pending order. © 2011-2021 VALUEWALK LLC. 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. 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. Nonetheless, there is a tail-risk to this liquidity in the sense that the liquidity is driven by other ETF holders and not a market maker. Certainly, the liquidity of the underlying assets helps describe the spreads in PIZ, IWM, and SPY observed above. 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. 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. If you can efficiently buy and sell the optimal product, other people’s volume is the least of your concerns. Markets can remain irrational longer than one can remain solvent. When this happens, what does the market maker do? One way the market maker makes money is by creating a bid/ask spread around the ETFs true tick-by-tick value. This also implies that an investor can sell MSFT at 47.31 and sell INTC at 36.49. In quadrant 3 (lower left) illiquid underlying assets DO NOT result in a liquid ETF. Answer: daily arbitrage opportunity. SPY is incredibly liquid and the spread is 1 cent, or 1/2 a cent on either side. The IWM has a 1 cent spread on either side, or ~1bp. Alpha Architect will use your information to provide blog updates and for email marketing. Similarly, on the buy transaction, an ETF buyer will pay $25.05 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. 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. 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). So the market maker buys the ETF from this secondary market … PIZ trades in international markets; IWM trades in small-cap stocks; SPY trades in mid/large cap stocks.
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