For advisors who are more used to trading mutual funds, exchange traded funds (ETFs) might seem like a different animal altogether. While they bear some basic resemblance – mutual funds and ETFs are baskets of stocks – their differences are what make it so important to understand the way ETFs actually work.
The Markets Aren’t What They Used To Be
Sometimes, you have to take it elsewhere to get your trades through.
The existence of people who facilitate the process of trading ETFs by providing a market for even the most thinly-traded fund is opening up new worlds for advisors and investors, making it possible for them to invest in ETFs that they once feared would be illiquid.
While what they do isn’t new – they’ve been around more or less as long as ETFs have –there are more now than ever before. And just like ETFs have made it possible for investors to access futures, currencies and far-flung global markets that previously were only open to institutions, alternate liquidity providers have expanded beyond institutional clients to registered investment advisors (RIA) and financial advisors. The services of liquidity providers give these advisors better access to price discovery and execution.
David Abner, director of institutional ETF sales and trading at WisdomTree, is one such person. In answer to the sharp uptick in ETF interest on the part of RIAs, Abner has emphasized the point that advisors need to consider volume and liquidity as separate issues. “Volume is a backward looking number, calculated as what has traded in the past,” says Abner. “Liquidity is a forward looking number, a number that can be traded based on the underlying basket.”
On the execution side of ETFs, advisors should look at how to make the market in the ETFs, patiently wait for orders to get filled or look to get someone to execute the order in the underlying security, adds Abner. A basic ETF faux pas that Abner brings up is the use of market orders. It’s more prudent to use limit orders. However, there is always the question: Is the limit in range? Will someone fill my order?
The big issue in trading large blocks is in how to find someone to create volume based on the underlying liquidity. Just because an ETF is trading at low volumes doesn’t necessarily mean low liquidity. There is a lot of liquidity in the underlying baskets, but one needs to be able to successfully access it. Abner notes that liquidity represents the number of shares that can be traded in the underlying security. So, it is possible to shift around large quantities of cash in low volume ETFs, but one needs to be more creative in the process.
True Liquidity
The common notions of liquidity in ETFs are not determinants of the true liquidity of an ETF. By having the right know-how, an investor may move large positions through the ETF market with relatively little impact.
It is most commonly asserted that investors should avoid funds with fewer than $100 million in assets and average daily trading volume of lower than 100,000 shares. But is it really that simple? The definition of true liquidity of ETFs could be better interpreted as a combination of the ETF’s average daily trading volume and the average daily trading volume of the underlying securities.
ETFs are said to trade in an arbitrage or derivative market. The value of ETFs comes from the value of the securities that underlie them. Underlying securities have values that are determined in an outright market, and the ETF’s value is expressed in relation to those securities. Deviation from the arbitrage-free price in the ETF provides an opportunity for profit to those savvy enough to take advantage of the deviation.
An ETF arbitrage process involves a creation/redemption process. Authorized participants, or APs, can “create” or “redeem” shares of the fund, thereby increasing or decreasing the number of shares outstanding in the market to accommodate shifting demand for the fund. APs create new shares of an ETF by swapping a basket of securities to the ETF sponsor for an equivalent value of newly created fund shares, and the AP can turn in ETF shares for securities. If the fund shares are trading at a discount to the fund’s net asset value (NAV), an AP buys the basket at NAV and shorts the fund shares above NAV at the same time. The AP would then exchange the basket for fund shares to cover its short position and lock in a profit.
Creation and Redemption Process Explained
The basic creation and redemption process of ETF shares is practically the exact opposite of mutual fund shares. When investors in mutual funds make redemptions, shares held within the fund need to be sold in order to raise cash to meet that redemption, triggering a taxable event. This isn’t always the case with ETFs, though.
The creation process is as follows:
- The creation process of an ETF begins with a prospective ETF manager, or sponsor, filing a plan with the Securities and Exchange Commission (SEC) to create an ETF.
- Once approved, the sponsor forms an agreement with an authorized participant (AP) – market maker, specialist or large institutional investor – who is able to create or redeem ETF shares.
- The authorized participant then borrows shares of stock and places them in a trust to form creation units of the ETF.
- The trust provides shares of the ETF that represent legal claims on the shares held in the ETF. The transaction is an in-kind trade where securities are traded for securities, which means no tax implications, since there was no cash changing hands.
- Finally, the AP receives the ETF shares, and the shares are then sold to the public as stocks in the open market.
The redemption process is as follows:
- First off, investors may sell shares on the open market – the more common option for investors.
- The second option is to hoard enough ETF shares to form a creation unit and then exchange the creation unit for an underlying security – the option more generally associated with institutional investors because of the large volume of shares required.
- When investors redeem, the creation unit is no more and the securities are handed over to the redeemer.
ETFs minimize tax liabilities by paying large redemptions with shares of stock and the shares with the lowest cost basis in the trust are given to the redeemer. The result is an increase in the cost basis of the ETFs overall holdings but a reduction in capital gains. The low turnover means that capital gains in ETFs are relatively rare as a result of the creation/redemption process.