Why ‘SPY’ Is King Of Liquidity

April 08, 2019

Matt Bartolini

[Correction: An earlier version of this article stated that SPY has the most short interest as a percent of assets of any ETF. That is inaccurate: The SPDR S&P Retail ETF (XRT) has the most short interest by percent of assets. However, SPY has the most short interest by dollar amount, as well as the most short interest by percent of assets of any S&P 500 ETF.]

The $268 billion SPDR S&P 500 ETF Trust (SPY) isn't just the biggest ETF or the oldest; it's also the most liquid. On average, SPY trades $18.3 billion daily, at a subpennywide spread. No other ETF even comes close.

How does that type of massive liquidity materialize? It's not just about assets under management, says Matt Bartolini, managing director of State Street Global Advisors and head of SPDR Americas Research. In fact, SPY's liquidity has as much to do with options traders and short-sellers as it does with trading in its own ETF shares.

Recently, ETF.com chatted with Bartolini to dig deep into common myths and misconceptions about the most liquid ETF on the market.

ETF.com: Why is SPY so liquid? If it's just a matter of its huge assets under management, would any fund that reached similar size become that liquid, too? 

Matt Bartolini: Clearly, SPY can tap into liquidity via the primary market. But the secondary market is where you find a lot of [liquidity], and it's provided by not just buy-and-hold traders, but more tactical traders, going either long or short. SPY has the most short interest as a percent of assets of any S&P 500 ETF. So that arbitrage fuels more liquidity, because you have dissenting viewpoints interacting in the same vehicle.

There’s also another leg of the liquidity stool, in that SPY has in the neighborhood of $400 billion worth of open option interest notional. That's basically 185% of its assets. That massive amount of options activity on SPY leads to even more liquidity.

ETF.com: How does having a deep options market influence the liquidity of an ETF itself?

Bartolini: Options activity creates liquidity because most options transactions require some sort of transaction in the underlying to hedge a market maker's position. If you’re an options market maker selling call options, to collateralize or hedge your position, you'd have to buy shares of SPY to deliver those shares. That creates more liquidity within the ETF.

ETF.com: So is SPY's options market big because the ETF itself is so big, or did that market grow for another reason?

Bartolini: SPY being first-to-market helped, and there's also already a big options market for instruments tied to the S&P 500 Index.

There's also an aspect of SPY's structure that helps. SPY is a unit investment trust, which allows it to have an extended calculation of net asset value, from a decimals perspective. Also, we can't reinvest our cash flow. So to someone hedging risk in a very precise manner, SPY's structure benefits them, because they know how much cash is in the portfolio at all times, in order to hedge out just the underlying equities [from the exposure].

ETF.com: The amount of precision you're talking about—it's relevant really only for the largest, multibillion-dollar institutions, though, not, say, mom-and-pop RIAs.

Bartolini: Correct. If you're more conscious on fees, something like the SPDR Portfolio Large Cap ETF (SPLY) offers very similar exposures, but for different use cases.

ETF.com: You've written about how even in the most volatile markets, SPY's spread stays constant, even when spreads on competing products widened. How does SPY's spread remain so consistent?

Bartolini: It goes back to the diverse user base. During periods of volatility, all these different avenues of liquidity converge on SPY, constraining the bid/ask spread to a low level. You have natural buyers and sellers coming to the market and trying to transact the most efficient price possible.  

In the middle of October [2018], SPY had nearly 1.5 million trades in a single day, all at a pennywide spread. So, many different investors all got that efficient execution. And when you have a positive client experience like that, you tend to go back. In Q4, SPY had served 40 million trades alone.  

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