Anyone can access exchange traded funds through a brokerage account. However, financial advisors should understand the inner workings of the ETF structure to implement cost-effective trades.
On the recent webcast, The Secret to ETF Trading: Understanding ETF Liquidity, Edward A. Rosenberg, Senior VP and Head of ETF Capital Markets & Analytics at Northern Trust Asset Management, reviewed best practices and common misconceptions regarding best executions in ETF trades.
While ETFs, like company stocks, trade on the stock exchange and can be accessed through a normal brokerage account, the funds are not driven exclusively by supply and demand but have an intrinsic value and are driven by the value of the underlying securities, Rosenberg explained.
Some traders may point to an ETF’s low trading volume and automatically assume the ETF is illiquid. However, since ETFs represent a basket of securities, an ETF’s true liquidity is based on the overall liquidity of its underlying holdings.
“ETFs always have more than one level of liquidity,” Rosenberg said.
For instance, in the secondary market, investors mya compare the volume and “on-screen” bid/offer data to gauge liquidity. Additionally, market makers provide further ETF market depth as they source liquidity for investors by allocating trades that are just pennies off the bid/ask price in the secondary market. Lastly, in the primary markets, ETF providers and Authorized Participants may identify additional liquidity through the ETF creation/redemption process.
The creation and redemption process helps facilitate large block trades in an ETF with low trading activity.
“The ETF creation process occurs when an investor enters an order to purchase a large number of ETF shares and there are not enough available shares on the secondary market,” Rosenberg said.
Unlike mutual funds, ETFs do not sell holdings in exchange for cash, which would trigger a taxable event. Instead, the ETFs undergo a creation and redemption process in which market makers, authorized participants or large institutional investors swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa.
An authorized participant would borrow shares of stock from an underlying benchmark and put them in a trust to form a so-called creation unit of an ETF. The Trust would provide shares of the ETF that are legal claims on the shares held in the ETF. As such, the authorized participant exchanges the basket of stocks for ETF shares, which are then sold to the public as stocks in the open market.
Conversely, ETF shares may be exchanged for a basket of securities from the underlying benchmark. Someone would have to hoard enough ETF shares to form a creation unit and then exchange the creation unit for shares of the underlying securities.
Advisors who are executing larger orders would then be more interests in an ETF’s implied liquidity.
“ETF implied liquidity is a representation of how many shares can potentially be traded daily in an ETF as portrayed by the creation unit,” Rosenberg said. “This is defined as the smallest value of the IDTs – implied daily tradable shares – for each holding in the creation unit.”
Advisors and investors interested in large ETF trade orders may find help through a capital markets desk to help execute a new position in a relatively inactive ETF with limited market impact.
Financial advisors who are interested in learning more about the best practices for trading ETFs can listen to the webcast here on demand.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.