Why ‘SPY’ Is King Of Liquidity

[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.  

ETF.com: Wow. It's astounding to realize how much more volume SPY trades than even some of its constituents. SPY even trades more in volume than Apple (AAPL), day-to-day.

Bartolini: Yes. It trades more than the entire GDP of Japan, and more than every single Dow Jones index stock combined. Essentially, you have to go down to the 92nd company in the S&P 500 ranked by market cap before you surpass SPY's trading volume, meaning that the top 92 combined trade less than SPY does.

ETF.com:  So how big a trade would you need before you actually moved the market in SPY?

Bartolini: It would require a trade of gargantuan size, one that we have never seen before and will likely never, ever see. In October, when the U.S. equity market sold off, equities traded something in the neighborhood of $300 billion. But ETFs [accounted for] only around 3.5% of underlying stock volume.

So it’s a big pool of liquidity out there in the single-stock space. For SPY to move the market would be, in my experience, impossible.

ETF.com: What do you think most investors really just don't understand about ETF liquidity?

Bartolini: Three things. The first is understanding what we mean by "liquidity." For example, a lot of peple look at average shares traded, because that's how you look at single stocks; like, Exxon (XOM) traded 50,000 shares, etc. In ETF land, though, you really want to focus on the dollar volume.

ETF.com: Why is that?

Bartolini: Because creation-unit size is different, and stock price is vastly different between a lot of these instruments that seemingly trade on the same type of security. You can have a U.S. equity fund with a $5 share price and one with a $300 share price.

You also need to think of that dollar-trading volume in relation to the rest of the ETF industry. A fund like the SPDR S&P Retail ETF (XRT) has a sizable amount of liquidity; it trades $300 million a day. Pretty good.

But that $300 million is 87% of its assets. So XRT can be a $1 billion fund one day, then a $300 million fund the next, because it's so heavily traded. Understanding those dynamics is important. XRT, while it may not trade as much as SPY, still has a strong liquidity profile. And it has basically 382% of its assets sold short right now, and 191% of its assets in options volume.  

Those three things—high trading volume, options and short interest—are what really make a liquid product, even though its asset base may only be $300 million to $400 million.

ETF.com: Does ETF liquidity still matter if you're a smaller investor, with a smaller asset base who isn't trading as much?

Bartolini: It matters to everybody. Bid/ask spreads are paid by everybody. You might not trade quarterly, monthly or even annually, but you have to think about how important trading costs are to your overall portfolio implementation.

The last thing I'll say is how important liquidity is during times of volatility, especially when you're heavily trading a portfolio. Going for the product with the lowest expense ratio may not actually end up being the lowest-cost product.

We’re constantly hearing, "Well, in periods of volatility, I just won't trade." While that may be true in most instances, there are some periods, like in the fourth quarter, where I'm hard-pressed to think no one was rebalancing their portfolios heading into year-end. Having the ability to tap into something extremely liquid, with consistency during periods of volatility—but also tranquility—can be additive to the portfolio construction process.

Contact Lara Crigger at [email protected]