Understanding the ETF creation/redemption process gives investors insight into an ETF’s overall liquidity across the primary and secondary market. Review the factors that impact bid/ask spreads and different options to make trading more efficient.
Becoming familiar with the ETF creation/redemption process is key to understanding the true extent of an ETF’s overall liquidity and achieving more efficient execution from a wider selection of funds. The creation and redemption process for ETFs takes place in the primary market and is facilitated by authorized participants (APs). APs are US-registered, self-clearing broker dealers who regulate the supply of ETF shares in the secondary market.
Creation is the process by which APs introduce additional shares to the secondary market. During this process, APs deliver the underlying securities to the fund sponsor in return for ETF shares. For redemptions, APs deliver ETF shares to the fund sponsor in return for the underlying securities. These transactions are executed in large increments known as unit sizes, which vary from 10,000 to 600,000 shares.
The ability to introduce additional shares into the marketplace on a daily basis demonstrates precisely why ETF trading volume is not an all-encompassing measure of the fund’s overall liquidity. To understand the full liquidity of an ETF, investors must also consider the liquidity of its underlying securities.
There are a number of reasons why an AP creates or redeems ETF shares, including: arbitrage, inventory management, customer facilitation, and create to lend. The two reasons that are the most applicable to investors are customer facilitation and arbitrage.
Figure 1: The ETF Creation/Redemption Process
The ask is the price at which an investor can buy ETF shares, and the bid is the price at which they can sell the shares. The difference between the bid and the ask is the spread, which indicates the overall cost of transacting in any security (plus any applicable brokerage commission costs).
ETF bid-ask spreads reflect execution costs, market risk, and the bid-ask spreads of the underlying securities in the ETF basket. These variables are all considered when institutional trading desks make markets for investors. Like most businesses, the cost to the end consumer is highly correlated with input costs. In this respect, ETF trading is no different from any other business. Therefore, ETF traders need to account for different categories of cost when facilitating ETF trades:
Although there are certainly a number of factors that contribute to the spread of an ETF, we believe there is one major factor that tends to compress spreads — secondary market trading volume in the ETF. Over time, as secondary market trading volume increases, there is a high correlation with tightening spreads.
As volume in an ETF rises, competition among market participants may compress spreads and allow investors to transact in a more cost-efficient manner in the secondary market. As ETFs mature, they may trade within an “arbitrage band” determined by the costs incurred by APs when creating and redeeming ETF shares.
In some cases, ETFs can trade above or below their intraday Net Asset Value (iNAV). This discrepancy is known as a premium or discount in the fund. ETFs may trade at premiums or discounts to their iNAVs due to several factors, including the bid-ask spread of their underlying securities, execution costs, investor sentiment, and market risk.
With respect to ETFs with international equity underlying, we tend to see greater premiums/discounts due to higher transaction costs and additional market risk. When analyzing these premiums and discounts, investors should keep in mind the difference between the trading hours of the underlying securities and those of the US-listed ETFs.
ETFs with fixed income underlying securities generally trade at a premium to NAV under normal market conditions. The main reason for this phenomenon is that fixed income ETFs trade at the midpoint (between the bid and the ask) of their underlying securities, while their NAVs are priced using the bid side — causing the differential, as the midpoint will be greater than the bid price.
However, during fear-driven market environments (taper tantrum, debt ceiling debate, or the oil selloff, for example), fixed income ETFs may see their premiums diminish and trade at a discount to NAV. In this case, the discount conveys market sentiment, as investors use the ETF as a price discovery tool.
It also reflects the risk that market makers face when selling the underlying cash bonds, as during bouts of volatility, some of the more illiquid fixed income securities may not be actively priced or traded.
There are two layers of liquidity within an ETF — available liquidity in the secondary market and liquidity of the underlying securities. In order to access all available pools of ETF liquidity, it is important to understand the various ways that investors can buy and sell ETFs.
The majority of ETF orders are entered electronically and match orders placed by natural buyers and sellers in the secondary market, where participants post bid and offer quotes at price levels that they are willing to buy or sell a particular number of shares at for a given ETF.
There are a number of different order types that can be used in the secondary market. Many investors utilize limit orders, which are orders to buy or sell a stated amount of a security at a specified price or better. The below example, which uses a hypothetical secondary market for ETF XYZ, reveals why investors should utilize limit orders when buying or selling an ETF:
|For illustrative purposes only.
If an investor placed a market order for 20,000 shares of XYZ, their average execution price would be $36.35, or $0.10 above the best offer at the time of execution. This is due to the fact that only 1,000 shares are offered at the best offer price of $36.25. The remainder of the trade is then executed at subsequent price levels until it has been fully executed. As a result, a market order for 20,000 shares would sweep through the available liquidity — in this case, at all four levels shown.
On the other hand, the investor could place a limit order at the best offer of $36.25, which would immediately execute 1,000 shares at that price. The remaining 19,000 shares would be bid in the secondary market at the same level until the order is filled.
This example highlights why market orders should generally be avoided when trading ETFs, especially with those that are more thinly traded. Although market orders provide faster execution of the entire order, the lack of control over the price can lead to unintended trading slippage.
With limited orders, the tradeoff is less immediate execution, but greater control over price. But one risk with limit orders: the entire order may not be filled. To increase the probability that the entire trade will be filled, investors can enter more aggressive limit orders at price points higher than that of the best offer in the secondary market.
Despite the efficiencies of the secondary market, investors may face situations where their trades outsize the available liquidity in the secondary market. In these circumstances, it may make sense to execute through an institutional trading desk. There are two common ways to execute large ETF orders with trading desks:
Each of these scenarios allows investors to access deeper pools of liquidity than those offered by the ETF itself in the secondary market. The main difference between the two is that the investor transfers market risk to the authorized participant and receives an immediate execution price in a risk trade, as opposed to creating ETF shares and taking on market risk until the end of day. The reason for using one over the other depends on the goals of the investor.
|Order is usually filled quickly
|No control over execution price
|Control over execution price
|Chance order will not be filled
ETF usage continues to accelerate as intermediary and institutional investors embrace ETFs for their inherent benefits, such as low cost, tax efficiency, intraday liquidity and transparency.1 Understanding the unique structure of ETFs allows investors to buy and sell them more efficiently.
Through strong relationships with authorized participants, market makers, liquidity providers, execution trading desks/platforms and stock exchanges, the SPDR Capital Markets Group plays an active role in supporting competitive markets and maintaining the SPDR ETF liquidity ecosystem.
The team’s insight into primary and secondary market activity — as well as access to numerous proprietary pre-trade liquidity analytics tools — can help you to evaluate execution strategies and meet your objectives, even in volatile markets.
ETFs Trade Like Equity Securities:
Investors and advisors should remember that an ETF is purchased, sold, and settled like an equity security. When buying or selling an ETF, investors should consider all of the factors they would when buying or selling a stock, as well as additional factors, like the total overall liquidity of the ETF.
Extreme Volatility Means Information Flow Can Be Less Efficient:
Under the efficient markets’ hypothesis, the stock market is viewed to be efficient and to reflect all publicly available information on securities. In periods of distress, the markets typically become less efficient. As a result of uncertainty in the broader markets, one may see bid-ask spreads or premiums/discounts to ETF NAVs widen for periods of time. Typically, these are temporary events. The extent to which the spreads widen is typically directly related to the perceived risk or volatility of the asset class.
ETFs Trade Effectively Even in Volatile Environments:
In the wake of periods of volatility, ETF trading volumes have increased sharply as investors look to ETFs for their key attributes of transparency and liquidity. ETFs can also function as price discovery tools, providing insights into the market’s view on correct market pricing, even during periods when the underlying liquidity for an asset class is diminished.