ETFs operate at two levels of liquidity. There is the liquidity of the ETF itself—the liquidity that’s quoted in your brokerage account—and the liquidity of what the ETF itself holds.
When you’re trading small numbers of shares, what matters most is the liquidity of the ETF itself. But as you start to trade 10,000, 50,000 or 100,000 shares at a time, the liquidity of what the ETF holds becomes more important. This is known as the “underlying liquidity.”
Why Underlying Liquidity Matters
Underlying liquidity matters because often, investors making large trades can get better pricing in an ETF than they otherwise might think.
Consider an ETF that holds very liquid securities—say, the S&P 500—but that only trades 100 shares a day. If you want to buy 100,000 shares of this ETF, you’d think you’d be out of luck.
But really, it should be no trouble at all. Because authorized participants can always create new shares of an ETF by buying up the underlying stocks and submitting them to an ETF issuer, an ETF can be considered as liquid as its underlying holdings.
ETF investors are fortunate in that they can access this ETF liquidity in multiple ways. The simplest way is to enter a reasonable limit order and hope a market maker fills the order. But more sophisticated investors and advisors will often partner with an outside firm to help facilitate those trades.
Here’s how they do it:
Step 1: Custodial Agreements And Prime Brokerage
The first step to trading with the help of a liquidity provider is contacting the party responsible for the custody of your ETP shares and assets. Typically, this is the party through which you usually trade ETF shares on an exchange. It's also the party responsible for the settlement of your securities. You’ll need to first be granted permission from them to “trade away” from its platform with a liquidity provider or market maker.
Keep in mind that custodians and prime brokers may charge a fee for trading away. It’s essential to determine the nature of this fee (variable or fixed) before deciding if the potential for trade execution quality outweighs the all-in costs of trading away.
Step 2: Understanding The Product And Capital Markets Help
Understanding the ETF you’re trading and the liquidity of the securities in the index it tracks is critical to a successful trade. When you contact a liquidity provider with whom to transact off-exchange, they will give you a quote based on what they believe to be a fair price for shares of the ETF … plus a little extra. It’s important to understand the fair value of an ETF, as well as the liquidity available in its underlying portfolio, so you can get a sense of whether this is a fair price. Sometimes that information is difficult to access without expensive data feeds. There is, however, a solution: the ETF issuer’s capital markets desk.
The capital markets desk at an ETF issuer is one of the best resources available to investors. Most issuers staff a desk whose sole purpose is to help investors enter and exit funds at fair prices. Among their many services, capital markets desks can run underlying portfolio analytics and give a clearer picture of the market impact of buying the underlying securities. They can also refer you to liquidity providers from their own network. Best of all, it’s free; why not give it a try?
Step 3: Selecting And Working With A Liquidity Provider
Selecting a liquidity provider is more art than science—it takes time, and some experience. It helps to stay with the trusted names, but also keep on the lookout for new parties that might be aggressive in their quoting in order to attract new business.
Remember, liquidity providers make their money off the flow (the number of shares you trade). On some days, they might quote aggressively because they can take on the risk in order to keep you as a client; on other days, they might quote less aggressively because they’re unwilling to take on the risk. Keep note of the types of ETFs you trade and with which liquidity provider. It’s likely you may notice some patterns regarding who offers the best prices for any given market.
Step 4: Post-Trade Analysis
After every execution, always obtain an independent post-trade analysis. It’s great if you’re satisfied with your off-exchange trade, but you’re not done until you do some price checking. A post-trade analysis allows you to understand the price at which your trade was executed relative to other transactions that occurred in the fund at the same time.
Making sure you didn’t overpay or undersell is something that should always be done. Sometimes liquidity providers offer third-party tools to conduct post-trade analytics. Still, the more independent the assessment, the better.