What is Chris talking about? So if someone wants to sell the ETF, they will get 24.95, not $25. 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. The INAV will be based on the prices associated with MSFT and INTC. So train yourself well, in order to think critically about your own financial situation. And here is the beauty of the ETF structure from the market maker’s perspective. m (Wiley, 2016). Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Ask more questions. "DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot.". In return, the ETF sponsor bundles the securities into the ETF wrapper, and delivers the ETF shares to the AP. 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. A market maker might post a bid at 24.95 and post an ask of 25.05. 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. The natural liquidity of ETFs trading in the secondary market is enhanced by exchange-registered traders called market makers. So the market maker buys the ETF from this secondary market participant at $83.75, and in order to hedge, he shorts the basket of names (MSFT and INTC) at $83.80. 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. 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. ValueWalk also contains archives of famous investors, and features many investor resource pages. At each transaction, the market maker has been buying, buying, and buying ETF shares. PIZ trades in international markets; IWM trades in small-cap stocks; SPY trades in mid/large cap stocks. How Portfolio Construction Impacts the Reliability of Outcomes, Democratize Quant Conference Recap and Materials, A Short Research Library Outlining Why Traditional Stock Picking is Challenging, ETF-prenuers: An Introduction to ETF White Label Services, Free Tool Announcement: Visualizing Unemployment Claims. What matters is how liquid the underlying shares are that make up the ETF. For example, let's say the value of the underlying basket of stocks in an ETF is worth $25. DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot. Answer: daily arbitrage opportunity. You are investing in a product that tracks an index. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. 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. Bond Ladders and Income Annuities: Simple is Beautiful. Market price is the trading price of an ETF share in the secondary market (i.e. On a tick-by-tick basis market makers track the “true” value of an ETF. Suddenly, the market maker looks up and has a HUGE position in the ETF (although it is hedged). As he sells the ETF "short" in the secondary market, he will simultaneously go into the market and go long the basket for $83.86, as a hedge. Consider an ETF that holds 2 stocks: MSFT and INTC. The spreads on these three ETFs seem to match up with the liquidity of the stocks they contain. Let’s say MSFT’s bid/ask is 47.31 by 47.35 and INTC’s bid/ask is 36.49 by 36.51. The INAV will be based on the prices associated with MSFT and INTC. 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. The secondary-market price of ETF shares may be more or less than the net asset value (NAV) of the underlying securities. Dr. Gray currently resides in the suburbs of Philadelphia with his wife and three children. This is a real-time price determined by trading activity on the stock exchange. Get comfortable. Let's go back to the "Secondary Market Sale" example from above. Regardless, if you attempting a very large transaction, it still makes sense to communicate with the ETF sponsor, so they can keep the market makers informed and ensure an orderly fill without spread impact. Given this information, the AP will sit back and think, "How do I make a market in TECH?" the stock exchange). Let’s say the current live net-asset-value based on mid-point prices on TECH is 83.83. Ask questions. Along with the price discovery benefit, the BoE highlighted the structural benefits of ETFs to have the ability to trade in the secondary market including the immediate liquidity at intra-day prices and the lower risk of a dynamic that leads to the fire sales of underlying assets. 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. jo.src = 'https://www.financialjuice.com/widgets/voice-player.js?mode=inline&display=1&container=FJ-voice-news-player&info=valuewalk&r=' + r; And here is the beauty of the ETF structure from the market maker's perspective. 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. If a large investor wants to put in an order to buy $1,000,000 worth at 83.91, they can get filled with little market impact--if they go about the process correctly--and let's not even consider the "primary" market, let's stick to secondary trading. Now let's say someone comes along in the secondary market, sees the posted Bid, and wants to sell the ETF at $83.75. Affiliated transactions. 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. 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 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. 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). To assess secondary market liquidity, follow an ETF at different times of day, over various time periods, and note how it’s affected by market environments. He has made the market, is fully hedged, and has made a small spread in the transaction. As it turns out, market making for ETFs differs in some fundamental ways from the type of market making associated with other listed securities. Several factors influence an ETF’s price in the secondary market, including the share-price movement of the underlying securities, currency exchange-rate movements (for international investments) and investors’ demand for the ETF. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. Though stocks are one of the most commonly traded securities, there are also other types of secondary markets. In the absence of another buyer or seller, a market maker can often match the other side of a pending order. Consider the TECH ETF. As shown below, breaking out volumes by daily price returns for the S&P 500 illustrates a volume smile trend — with higher volumes on both above and below +/-1% days (i.e., the big up and down days in 2020). The average daily trading volume (ADV) is a measure of this activity, but it doesn't indicate an ETF's total liquidity. 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. Ask questions. Moreover, for huge trades, communicate directly with the market maker or your ETF trading desk. 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. https://alphaarchitect.com/2014/12/03/trading-etfs-in-the-secondary-market And while popularity and interest certainly contribute to liquidity, the real driver of liquidity in an ETF is the liquidity of the underlying assets that the ETF holds. 4. Here are some example limit books from 11/26 (~9:35am) on PIZ, IWM and SPY. 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. Unsubscribe at any time. At each transaction, the market maker has been buying, buying, BUYING ETF shares. Ask more questions. To buy the underlying in TECH, it would cost 83.86 (47.35+36.51) and to sell the underlying in TECH it would net 83.80 (47.31+36.49). Trade ETFs when the underlyings are liquid--avoid trading ETFs at the open or when overall market volume is lackluster. Someone has to buy the computers, pay the employees, and pay the rent to keep the lights on at the market making shop. Note: Bloomberg has a really cool feature called implied liquidity, which allows ETF buyers to better grasp the true liquidity of an ETF.. Which Berkshire Business Would You Sell Off Assuming No Tax Hits? Go forth and compound, If you liked this post, don’t forget to subscribe to Alpha Architect. Find a broker that understands how to access the cheapest and most efficient liquidity at the moment in time you need to trade. No liquidity, means no love when it comes to buying/selling. These newly created ETF shares are then introduced to the secondary market, where they are traded between buyers and sellers through the exchange. They compare these two "theoretical" portfolios to the live net asset value of the ETF. They don't require secondary market volume to unwind the hedged book -- the market maker can simply redeem an ETF unit, and simultaneously cover his shorted basket of MSFT and INTC. Better trading and execution will lead to better returns and happier investments. An ETF’s liquidity has everything to do with the underlying liquidity of the positions the ETF holds. SPY is incredibly liquid and the spread is 1 cent, or 1/2 a cent on either side. Secondary liquidity is … When this happens, what does the market maker do? 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. 15-seconds doesn’t sound like a long time, but in the context of intra-day markets, 15-seconds can be an eternity. 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. However, when trading an ETF, ZERO shares traded doesn't really matter. APs present a basket of securities to create ETF shares (or, conversely, receive a basket of securities to redeem ETF shares). Market makers are in the business of making markets, which costs money. This will prevent the APs from being “surprised” by a huge order. Pretty liquid. ETF share in secondary market trading We can also calculate the ETF footprint on the secondary market (i.e. The IWM has a 1 cent spread on either side, or ~1bp. Consider the TECH ETF. 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). He has made the market, is fully hedged, and has made a small spread in the transaction. We won't send you spam. You’ll notice that this mid/large domestic-focused ETF is illiquid at open because the underlying names are illiquid. An educated investor can defend against the financial services industry, which is a marketing juggernaut, and doesn't always have your best interest in mind. There you'll need to first find the quoted price and the number of shares available at that quote. What matters is how liquid the underlying shares are that make up the ETF. An ETF is simply a basket of securities that are publicly traded in the marketplace. Find a broker that understands how to access the cheapest and most efficient liquidity at the moment in time you need to trade. The focus for today is understanding how markets are made in ETFs. 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. 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. DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot. You are investing in a product that tracks an index. This also implies that an investor can sell MSFT at 47.31 and sell INTC at 36.49. I have read and agree to the Terms & Privacy Policy. dedicated to an impact mission of empowering investors through education. 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. The majority of ETF trading occurs in the secondary market, where investors buy and sell existing shares of ETFs on-exchange or over-the-counter (OTC). We respect your privacy. Please speak to a licensed financial professional before making any investment decisions. Given this information, the AP will sit back and think, “How do I make a market in TECH?” Being a profit-minded AP, they might set their market prices as follows: Now let’s say someone comes along in the secondary market, sees the posted Ask, and wants to purchase the ETF at $83.91. You'll notice that this mid/large domestic-focused ETF is illiquid at open because the underlying names are illiquid. There are two important corollaries here for ETF investors. 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. Understanding How ETFs Trade in the Secondary Market. 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. As stated earlier, ETFs, like stocks, are trading on the secondary market. Well, if you notice the 3 limit books from above, they have three different spreads and trade in three different asset classes. If the underlying assets are illiquid, expect the ETF to be illiquid; if the underlying assets are liquid, expect the ETF to be liquid. (function () { This means that an investor can buy MSFT at 47.35 and buy INTC at 36.51. Someone has to buy the computers, pay the employees, and pay the rent to keep the lights on at the market making shop. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). 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. Now let's say someone comes along in the secondary market, sees the posted Bid, and wants to sell the ETF at $83.75. Being a profit-minded AP, they might set their market prices as follows: Now let's say someone comes along in the secondary market, sees the posted Ask, and wants to purchase the ETF at $83.91. The spread is 9 cents, or roughly a 4bps spread on either side. In quadrant 3 (lower left) illiquid underlying assets DO NOT result in a liquid ETF. On a tick-by-tick basis market makers track the "true" value of an ETF. Chris’ final words: This year's Sohn 2021 Investment Conference featured Patrick O'Shaughnessy in conversation with Karen Karniol-Tambour. Let’s say that secondary market participants relentlessly hit the market maker’s Bid at $83.75. var jo = document.createElement('script'); Breaking down volumes based on market movements furthers the notion of secondary market ETF trading providing additive liquidity benefits during periods of market stress. When demand increases, more ETF shares can be created using this process. The most visible source of ETF liquidity is the trading activity of buyers and sellers in the secondary market that takes place on an exchange. Market makers don't track the tick-by-tick value of an ETF for their health--they do it so they can make money! Let’s work through an example so you can understand how these market makers think. As Chris highlighted in his interview: DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot. Let's say MSFT's bid/ask is 47.31 by 47.35 and INTC's bid/ask is 36.49 by 36.51. As Chris mentioned, “DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot.”.
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