Liquidity is one of the most important features attracting a diverse group of investors to exchange traded funds (ETFs). To understand where ETF liquidity comes from, explore the mechanics of ETF trading and the roles played by key members of the liquidity ecosystem.
An exchange traded fund (ETF) is an investment vehicle whose shares trade intraday on stock exchanges at market-determined prices.
ETFs are unique because they offer two markets for trading:
Figure 1: The ETF Liquidity Ecosystem
The below explains the key ETF trading activities highlighted in Figure 1.
ETFs’ unique creation and redemption process and secondary market trading involve a number of capital markets players who contribute to the ETF liquidity ecosystem, including:
- Institutional Sales and Trading Desk: Some brokers have a dedicated institutional trading desk that specializes in facilitating large trade executions at defined prices. They may quote a market for a given ETF at a given size (risk trade) or act as an AP to place a creation or redemption order on the client’s behalf with the ETF issuer (end-of-day NAV trade).
- Lead Market Maker (LMM): Selected by the Primary Listing Exchange, LMMs are required by the exchange to meet minimum performance standards, such as best bid and offer, minimum displayed time, and minimum quoted spread. In exchange, LMMs receive economic benefits, such as lower transaction fees and higher rebates from the exchange.
- Electronic Market Makers (EMM): EMMs employ algorithmic and high-frequency trading technology to harvest bid/ask spreads with relatively high trading volume in a short period of time without human interaction. They usually minimize using their balance sheet by making their positions market neutral by the end of the day.
Each of these capital markets players contributes to ETFs trading more efficiently throughout the day, which benefits both buyers and sellers. There are also economic benefits for the capital markets participants.
The ETF issuer develops ETF products, determines fund investment objectives, manages the ETF portfolio according to the fund’s objectives and oversees day-to-day operations. Within the organization, these four functions deal with market liquidity:
Figure 2: Economic Incentives for ETF Market Participants
|Buyer/Seller of ETF Shares||Buys ETF shares at a lower price and sells at a higher price later.|
|Trading Venue||Earns revenue from transaction fees paid by market participants trading on their platform. Listing exchange also earns listing fees paid by ETF issuers.|
|Broker||Earns commissions by fulfilling client buy/sell orders through finding matches in the secondary market.|
Profits from spreads of their bid/ask quotes. Arbitrages between an ETF’s intrinsic value and its market price.
|Lead Market Maker (LMM)||Profits from spreads of their bid/ask quotes. Arbitrages between an ETF’s intrinsic value and its market price. Receives economic incentives from the exchange, such as lower transaction fees and higher rebates.|
|Electronic Market Maker (EMM)||Captures arbitrage opportunities by using high-frequency trading algorithm.|
|Institutional Sales and Trading Desk||Earns commissions by providing market making services to institutional clients for their large transactions.|
|Derivative Trading Desk||Maintains risk neutral of their total portfolio by trading a wide range of financial instruments, such as ETFs, swaps, and index futures.|
|Short Seller of ETF Shares||Profits from falling ETF share prices. Borrows ETF shares, sells them now, and buys back later at a lower price to return shares to the lender to make profits.|
|Create-to-Lend Desk||Driven by clients’ demand of borrowing ETF shares. Profits from lending fees.|
|Authorized Participant (AP)||Acts as an agent for market makers and other liquidity providers to create/redeem ETF shares and earn commissions. Some APs also earn revenue through market making activities.|
|ETF Issuer||Earns fees as a percentage of fund net assets.|
State Street launched the first US-listed ETF in 1993 — the SPDR® S&P 500® ETF (SPY). Since then, ETFs have become an increasingly popular investment vehicle for both individual and institutional investors. Improving education about how ETFs are structured and traded is vital to helping investors understand the potential benefits of investing in ETFs, including the multiple layers of liquidity they offer.
The difference between the highest price a buyer is willing to pay for an asset and the lowest price the seller will accept to sell. Bid-ask spreads are a key measure of the liquidity of an asset or security.
The marketplace where securities, commodities, derivatives and other financial tools such as ETFs are traded. Exchanges, such as stock exchanges, allow for fair and orderly trading and efficient circulation of securities prices. Exchanges give firms looking to market publicly listed securities the platform to do this.
Exchange Traded Fund (ETF)
An ETF is an open-ended fund that provides exposure to underlying investment, usually an index. Like an individual stock, an ETF trades on an exchange throughout the day. Unlike mutual funds, ETFs can be sold short, purchased on margin and often have options chains attached to them.
The ability to quickly buy or sell an investment in the market without impacting its price. Trading volume is a primary determinant of liquidity.
Net Asset Value (NAV)
The price of a share determined by the total value of the securities in the underlying portfolio, less any liabilities.
The market where Authorized Participants (APs) create and redeem ETF shares in-kind, typically in blocks of 50,000 shares, which are known as creation units.
The market in which ETF shares or common shares of public companies that currently exist are traded on exchanges between investors.
Important Risk Information
There can be no assurance that a liquid market will be maintained for ETF shares.
Investing involves risk including the risk of loss of principal.
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The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
Diversification does not ensure a profit or guarantee against loss.
Passive management and the creation/redemption process can help minimize capital gains distributions.
There can be no assurance that a liquid market will be maintained for ETF shares.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
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Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.