American Century: Tools Of The ETF Trade

October 29, 2018

[This ETF Industry Perspective is sponsored by American Century Investments.]

Many investors think of exchange-traded funds (ETFs) as “mutual funds that trade like stocks.” While this characterization is accurate as far as it goes, it is incomplete: ETFs trade on exchanges throughout the day like stocks; however, there are important differences between the dynamics of stock transactions and those of ETF transactions.

With stocks, volume generally signifies liquidity. For ETFs, this is not the case: Volume is only a reflection of what has traded, not what could have traded.

This article will discuss the layers of ETF liquidity. It is because of these layers that the ETF volume that is shown is not a true reflection of what could have been traded. As part of this discussion, the article will provide an overview of the ETF creation and redemption process, which is the key to unlocking ETF liquidity. We will also examine other trading attributes that investors should be aware of when trading ETFs.

Going Deeper
As Figure 1 shows, there are three levels of liquidity for an ETF. Let’s explore each layer in more detail.

Level 1 – Secondary Markets
ETFs trade similarly to stocks (see Stock Trading in a Nutshell below). The simplest way for an ETF to trade is for a buyer and a seller to be matched on the secondary market. The National Best Bid and Offer (NBBO) quotations present the publicly available view of the NBBO and reflect the size and bid/ask spread (often referred to as the “spread.” (See below for more on spreads.)

Unlike stocks, however, ETF prices generally reflect the value of the underlying securities contained in the fund. These spreads can be influenced by a variety of factors:

  • Types of Underlying Securities – ETFs that consist of securities from efficient and liquid asset classes (such as U.S. equities) generally carry tighter spreads than less liquid/less efficient asset classes (such as high yield corporate bonds).
    ETF spreads generally behave similarly to the types of securities they hold, so it’s important for investors to understand what the ETF owns.
  • Volume – The higher the volume traded of an ETF, the more likely it will trade with spreads tighter than the underlying securities.
  • News – News that creates uncertainty in the market is likely to cause spreads to widen. Examples include company-specific news, country or regional news, or governmental news.
  • Market Volatility – Overall market volatility brings uncertainty into the market and therefore uncertainty of the exposure the ETF provides, which could cause spreads to widen.
  • Authorized Participant (AP) Costs – An AP is a broker/dealer that is contractually authorized to create and redeem ETF shares directly with the fund. These costs can be a factor in ETF spreads.

Differences in the bid/ask spreads among ETFs can have a meaningful impact on both trading cost and total return, so it’s important for investors to take them into consideration when making investment decisions.

A word to the wise about comparing ETF spreads: Wider spreads do not always mean an ETF is more expensive than one with a smaller spread. The best way to illustrate this is in the following example. In this example, ETF A and ETF B have similar exposures, and all other attributes are the same.

This example illustrates that an investor, instead of comparing spreads on an absolute basis, should compare the spread’s percentage impact on the share price. In this case, given that the two ETFs have equivalent exposures and attributes, ETF A would be cheaper to own than ETF B, even though ETF A has a wider spread.

To summarize, an ETF investor should note the NBBO, particularly the size at which the market is offering to buy or sell a trade. This assessment should give an investor an idea whether a market trade may move the price of an ETF. This is important, because filling an order that is larger than the NBBO will require accessing other quotes that may be wider. It is recommended that an ETF investor utilize a limit order (discussed in more detail in Trading Tips and Tactics) when placing trades to protect the order from moving the ETF price beyond the NBBO.

* Basis points (bps) are a unit of measure that describe percentage differences of less than 1%. 100 basis points equal 1%.

Level 2 – ETF Market Depth
As mentioned previously, NBBO quotations represent liquidity (price and size) available from market makers who post quotes through a stock exchange. They do not, however, reflect the full depth of the ETF marketplace.

Market makers have the option of showing more than one level of quotes. The market depth is not easily seen by the average investor, but can be accessed by broker/dealers’ ETF block desks. It can also be accessed by placing a limit order that is beyond the NBBO – generally, a few pennies below the bid or above the offer. The spreads beyond the NBBO represent additional costs, as discussed above, for market makers to provide ETF liquidity.

The following is a view of an ETF order book showing market depth:

Level 3 – Primary Markets
The primary market is the greatest source of ETF liquidity. Through the creation and redemption mechanism, a broker/dealer or market maker can meet the demand for ETF shares by buying and selling the underlying securities, using their natural liquidity. The broker/dealer or market maker will then use an AP of the fund to create or redeem ETF shares. Any time supply and demand are not aligned, a market maker steps in, through the AP, to initiate the ETF share creation and redemption mechanism, generally in multiples of 50,000 or 100,000 ETF shares. This process is described below.

How does the creation and redemption mechanism work?
As illustrated in Figure 3, when demand exceeds supply, ETF share creation gets underway to ensure there are a sufficient number of ETF shares available to fill an investor’s order. In a creation transaction, an AP assembles a portfolio (frequently called a “basket”) comprising the current holdings of the ETF. The AP turns the basket over to the ETF custodian. In exchange for the basket of securities, the ETF custodian delivers a designated number of ETF shares to the AP. The basket and the number of ETF shares delivered are equal in value. ETF share redemption reverses this process when excess supply needs to be removed from the marketplace. As a result of the creation/redemption process, supply and demand generally remain in balance, and the share price of an ETF does not stray far from the value of its underlying securities.

To summarize, the creation/redemption mechanism helps the ETF remain liquid and maintain its price in line with the value of its underlying securities. We have seen how, in practice, the ETF takes advantage of the liquidity of its underlying securities to ensure equilibrium is maintained between supply and demand. For large orders, a broker/ dealer’s ETF block desk can help an investor access all layers of ETF liquidity, including the primary markets.

Where The Rubber Meets The Road: Trade Execution
Now that we understand ETF liquidity, let’s look at the various trading strategies that might be appropriate under different circumstances.

Figure 4 outlines a possible trade decision-making process that taps the three levels of ETF liquidity for an investor seeking to purchase 10,000 shares of an ETF.

Trading Tips And Tactics
There are a few simple steps that can give investors greater confidence in placing ETF trades. While there are no hard-and- fast rules that apply under all circumstances, different situations and investor objectives call for differing tactics.

An investor should consider the type of order – market, limit, stop or stop limit. No one approach is best in all situations, so it’s important to understand the potential benefits and limitations of each and choose the one that best fits the specific circumstance.

Best Practices
There are also some best practices to keep in mind and factors to consider when trading an ETF to help ensure best possible execution.

Call On ETF Capital Markets
This article has presented an overview of the dynamics involved in trading ETFs with the focus on the three levels of liquidity, execution considerations and tips to trading. Additional resources are available for more information.

ETF capital markets experts at issuers and broker/dealers are available to guide you through your ETF trading strategies, help bring about a positive trading experience, and achieve the best possible execution to help meet trading objectives.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice. The information in this document does not represent a recommendation to buy, sell or hold security. The trading techniques offered in this report do not guarantee best execution or pricing.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Exchange-traded funds (ETFs) are bought and sold through an exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.

For more information on the terms listed above, please see our glossary.

Advisors: For more information, please see Matt Lewis's paper Tools of the ETF Trade (log-in required).

Disclosures

Exchange Traded Funds (ETF) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

The opinions expressed are those of Matt Lewis and are no guarantee of the future performance of any American Century Investments fund.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

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