Understanding ETF Liquidity

Two sources of liquidity

Assessing the overall liquidity of an ETF requires you to consider the liquidity in both the secondary and primary markets together:

• Secondary market transactions are those involving the purchase and sale of existing ETF units. These typically take place on exchange—although they also include bilateral over-the-counter block trades—and do not involve the ETF manager. The liquidity in the secondary market is usually measured by average daily trading volumes as recorded in the systems of the exchange where the ETF trades. The open-ended nature of ETFs means they have a unique share creation/redemption process. 

• Primary market transactions are those that result in the creation or redemption of new shares. These take place off exchange and directly involve the ETF manager. The liquidity in the primary market is derived from the liquidity of the underlying securities, and large transactions can be processed by leveraging the liquidity of the underlying market.
  

Primary market: creations and redemptions

Primary market activity—the process by which ETF units are created and redeemed—plays a crucial part in determining an ETF’s true level of liquidity.

Creation is the process by which approved Authorised Participants and stockbrokers apply for units in an ETF and introduce additional shares to the secondary market. Authorised Participants create fund units in large increments—known as creation units—by assembling the underlying securities of the fund in their appropriate weights to reach creation unit size (e.g. 500,000 units) and then delivering those securities and/or cash to the fund. In return, the Authorised Participant receives units, which they can then sell in the secondary market, increasing the supply of units that can be traded by other investors.

Authorised Participants can also redeem units through the same process in reverse. The AP collects large increments of units—known as redemption units—in the secondary market and then delivers them to the fund in exchange for cash and/or the underlying securities in their appropriate weighting equalling the redemption unit (e.g. 50,000 units). This reduces the supply of units available in the secondary market.

From the ETF and its investors, this process serves to keep the market price of the units and the net asset value (NAV) in line. The Authorised Participant can profit from creating or redeeming units in a number of ways, including arbitrage, inventory management, customer facilitation and equity finance/stock loan.

Secondary market: the bid-ask spread

Although the price of units in an ETF should be closely related to the value of the ETF’s underlying assets, the relationship can fluctuate to some extent. This can manifest itself in two main ways: changes in the width of the bid-ask spread and changes in the premium or discount between the ETF price and the value of its assets.

Studies have shown there is one main factor that tends to compress the bid-ask spread of an ETF: secondary market trading volume of an ETF. Over time, as volume in an ETF rises, competition lowers spreads and allows investors to transact in a more cost–efficient manner in the secondary market.

Accessing deeper pools of liquidity

Despite the efficiencies of the secondary market, investors may also face situations where their trades simply out size the available liquidity in the secondary market. In these circumstances, it may make sense to execute through a liquidity provider or a block trading desk, which acts as an intermediary between two parties and specialise in facilitating large trades arranged at defined prices—otherwise known as “block trades”.

Two common ways to execute large ETF orders with trading desks or liquidity providers are via a risk trade or an end of day NAV trade. Both ways allow investors to access deeper pools of liquidity than are offered by an ETF itself in a secondary market.

• Risk Trade: One way investors can interact with a liquidity provider is through a risk trade. With a risk trade, a liquidity provider/institutional trading desk will quote a market for a given ETF at a given size. If the client finds the price agreeable, then the trade is executed. This may be advantageous to clients looking to execute their large orders quickly and at one price. The reason this is referred to as a risk trade is because once the trade is executed, the liquidity provider assumes the market risk of the position and will work to hedge the position to limit risk. If the trade is large enough, the liquidity provider may create or redeem units to complete the trade.
• NAV + Trade (Creation and Redemption): Investors can also work with a trading desk or Authorised Participant to place a creation or redemption order on their behalf with the fund sponsor. In this scenario, the price the client pays for the shares is based upon the ETF’s closing NAV, as well as any implicit costs that the Authorised Participant incurs in the process of creating or redeeming shares. These costs include executing the underlying securities and the creation fee charged by the ETF sponsor. Given the nature of a NAV + trade, market risk is accepted by a client until an order’s NAV is determined.
  

Investors should look to utilise the full range of resources available to them when trading larger orders—such as execution desks, liquidity providers, and subject matter experts like the SPDR Capital Markets Group—and not shy away from ETFs with small AUM or lower trading volume if they believe the product provides a unique strategy to satisfy their investment needs. 

As one of the first dedicated ETF Capital Markets teams established in Asia Pacific, the SPDR Capital Markets team oversees the SPDR ETF Trading ecosystem and manages relationships with Authorised Participants, Market Makers, Exchanges, Platforms, and Broker Dealers. 

For any questions related to ETF Trading and Liquidity, please do not hesitate to contact the team at APACSPDRCapitalMarkets@ssga.com.