ETF liquidity: Look beneath the surface
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:
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.
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.
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.
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.