Exchange-traded funds (ETFs) are considered excellent investment vehicles for a good number of reasons, but one of the most significant is their liquidity. ETFs have some internal mechanics that make them very different from a typical equity product. The most glaring is the fact that ETFs have what is called continuous issuance of shares via the creation and redemption mechanism. This feature enables rapid expansion or redemption of shares outstanding in an ETF and is the main facilitating feature that has enabled ETF volumes and assets to grow. It is this creation and redemption functionality that unlocks all of the underlying liquidity in an ETF, making it accessible to every investor. Volume and liquidity are the keys to the ETF world. Understanding that you can utilize an ETF that trades infrequently in the market by accessing its underlying basket enables you to expand your personal product universe. This will give you tools to expand portfolio access and manage risk that were previously unavailable.
The growth of trading volume in the most actively traded ETFs has been nothing short of phenomenal. ETFs now account for more than 18% of US equity trading volume. ETF trading often exceeds 2 billion shares per day. Most of the increase in ETF volume has been in the most actively traded funds. A number of studies measure trading volume in terms of the value of the traded shares rather than the number of shares. The high per-share price of the SPDR S&P 500 and a few other ETFs helps account for the fact that ETFs account for 30% of equity trading by value and the 20 most actively traded ETFs account for about 80% of total ETF volume by value. Typically, between one-third and one-half of the most active stocks listed each day in the Wall Street Journal are ETFs. Regardless of the unit of measure, most of the hundreds of ETFs listed in the United States do not trade very actively.
There is always a lot of heated debate about the average daily trading volumes of ETFs. There are arguments saying that the extremely high volumes generated by people pursuing arbitrage opportunities in ETFs are bad for the investing community. And there are arguments saying that the low trading volumes in ETFs are an indication of faulty product development. Neither may be true. Higher trading volumes are beneficial for everyone because of the increased liquidity that all participants can take advantage of for their own purposes. And, since low-volume ETFs are still in a structure that can handle rapid swings in volume and rapid changes in fund size, their average daily trading volumes do not indicate either fund success or product development problems. There is a long history of ETFs existing in the market for an extended period before attaining a notable amount of assets. With the added expenses of listing funds now as compared to several years ago, fund companies may no longer have the luxury of extended wait times for smaller products.
Typically, the goals for volume from an issuer standpoint start with the first stage to get volume above 100,000 shares per day. Stage 2 would be to get the volume above the 500,000-shares-per-day range. Once a product starts trading comfortably over that range, additional trading firms and investors come in, taking the product to over 1 million shares daily in a short time span.
Liquidity is a significant part of what makes ETF funds accessible, manageable, and accurate. A large proportion of ETF trades take place between a bullish or bearish viewpoint and a liquidity provider. An investor wants to buy or sell. Instead of buying from another investor with an opposing viewpoint, the investor typically is trading versus a liquidity provider. An ETF acts like a derivative whereby its value is derived by an underlying basket of securities. A position in the ETF can then be hedged by utilizing the underlying securities or asset, thereby reducing the potential risk to a liquidity provider. This trading versus a liquidity provider is especially true of many of the lower-volume ETFs.
In the very high-volume ETFs, there are so many arbitrage participants continually competing with ever-tightening spreads to squeeze out any potential margins, that actual lead market makers (LMMs) are not critical to the daily order flow, so they become a smaller percentage of the volume in the market.
Alternatively, in the newer, typically lower-volume ETFs, the LMM is important, playing the role of product caretaker, helping these products to grow by providing opposing liquidity against client order flow. In many cases, there is an opportunity for a liquidity provider to take the other side of an ETF trade, achieving 2 simultaneous goals:
- Satisfying customer demand to buy or sell the ETF
- Taking advantage of a spread between the price at which the ETF trade takes place and the price at which the basket or hedge can be executed
This has been beneficial for the ETF business because issuers are able to launch products and liquidity providers and LMMs are able to take the other side of the ETF order flow to facilitate initial trading, achieving both goals simultaneously. This is primarily achieved via the creation and redemption mechanism embedded in the ETF structure, which has proven to be the most important compared to traditional equity and competing structures.
The beauty of the arbitrage mechanism in the ETF is that it has created an entirely new ecosystem for trading in the markets. Whereas in the past there were only about 5 equity indexes on which you could pursue arbitrage opportunities between baskets and the futures, now there are hundreds of arbitrage opportunities between baskets and ETFs. The ability to trade baskets of stocks as separate individual equities or as a unit has created arbitrage revenue streams previously available only to the index arbitrage trading desks in a limited fashion. As more and more indexes are created and ETFs are issued on those indexes as replication vehicles, the opportunities to take advantage of arbitrage spreads have grown as well.
The process of creation and redemption in an ETF is very different from what happens in a closed-end fund (CEF) and impacts both volume and liquidity. A CEF always has a fixed amount of shares outstanding. If you are buying shares in the secondary market, there is no way for your counterparty to access the primary market for the issuer to create more shares, so you actually will create pressure on the fund price. If you want to buy 100,000 shares of a CEF with 100,000 shares outstanding, you could have a significant effect on the price of the fund as you vacuum up all of the available shares in the marketplace.
A similarity between ETFs and mutual funds is their open-ended issuance function. In the case of a mutual fund, investors are delivering cash and a portfolio management team is going out and buying the basket of shares for the portfolio and then issuing you shares of the fund. In contrast, with the ETF, the LP is buying the basket of shares for the portfolio and delivering them to the ETF issuer in the proper format. This is what leads to the tax advantages of the ETF structure; a fund manager buying and selling stock will create taxable events within the fund. Since an ETF is receiving and delivering its stock holdings as part of an in-kind transaction, the portfolio can be managed in a more efficient manner.
Of course, liquidity is ultimately correlated to the underlying asset. As ETFs expand into more complex assets and away from traditional equities, their liquidity tends to shrink. It’s important to recognize the direct relationship between the complexity of the underlying asset and the complexity of the derivative investment vehicle which holds it (in this case, ETFs).
Trading volumes of ETFs themselves tell a very interesting story. They do not, however, tell the whole story. Currently the market for ETFs is expanding quickly in terms of various products offered, but the assets flowing into those new products are moving slowly. Part of the problem is that techniques in facilitating trading flows have not advanced as quickly as demand.
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