Understanding ETF liquidity

BY Alistair Mills | 11 April 2017
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Exchange Traded Funds (ETFs) are well known for their low cost and diversification benefits, however, their level of liquidity and ability to closely track the price of the underlying securities they hold are advantageous for investors but tend to be less well known and sometimes misunderstood.

To understand how ETFs maintain this ability, it is important to understand their structure.

The structure of an ETF is known as ‘open-ended’. This means that there is no limit to the number of units able to be offered on the market. It is this structure that leads to the often quoted concept that an ETF is as liquid as the underlying securities it holds.

The open-ended structure of an ETF creates two tiers to the market on which ETF units are bought and sold.

Primary Market

The Primary Market is where new units are issued or redeemed directly by or from the ETF.

ETF units can only be created or redeemed by an Authorised Participant (‘AP’). An Authorised Participant is a large financial institution (for example Morgan Stanley, Goldman Sachs or equivalent) who has an agreement with the ETF issuer, such as BetaShares.

ETF creations can be achieved either through ‘cash’ where the Authorised Participant exchanges a dollar amount for a number of units of a particular ETF (or a “creation unit”); or ‘in-kind’, where an Authorised Participant acquires the securities the ETF is looking to hold and exchanges them for equivalent ETF units.

Importantly, as a result of this open-ended structure, if there is higher demand in the market than the current number of units available, Authorised Participants can ‘create’ more units and increase the number available on the market. In contrast, if demand for the ETF is lower than the current number of units on the market, Authorised Participants can ‘redeem’ units and reduce the number available on the market. This mechanism gives ETFs their liquidity – so long as there is liquidity in the underlying exposures, the AP will always be able to create/redeem to meet demand and supply needs.

Since ETF units trade like individual securities on the ASX, they may be subject to price fluctuations during the trading day as a result of the prices of the underlying securities within the index the ETF aims to track.

The ETF creation/redemption mechanism additionally assists the ETF unit price to stay close to the fair value of the underlying basket of securities.

To explain how, if the Fund begins to trade at a premium compared to the securities it holds, Authorised Participants will recognise an overpriced ETF and can purchase the underlying units which make up the ETF, exchange them for ETF shares and sell these on the market. Through this, they can take advantage of the difference in price, also known as an ‘arbitrage’.

This increased supply of ETF units will, in turn, tend to bring the market price for ETF units back down towards the fair value of the underlying securities it holds.

With Authorised Participants monitoring our ETF unit prices relative to market, BetaShares’ ETF market prices typically stay closely in line with the fair value of their underlying securities during the trading day.

Secondary Market

The secondary market is where securities are traded on an exchange, and where end-investors buy and sell ETF units.

‘On-screen’ liquidity derives from other unitholders buying and selling units amongst themselves, but also due to the presence of dedicated Market Makers.

Market Makers (‘MM’s) are responsible for “offering” BetaShares ETF units on the ASX with the aim of ensuring liquidity is available during the trading day. Market Makers compete for customer orders by displaying buy and sell quotations. The difference between the buy and sell quotations is the ‘spread’ and this is how market makers earn their fees.

Market Makers do not have a view on the market. Their positions are constantly hedged, with the aim to have a net exposure to the market of zero. As a result of this, they will always look to provide a market on both sides of the trade as long as they can hedge their position accordingly.

In order to price their positions, Market Makers receive the composition of the ETF basket from BetaShares before market open, which enables them to price the ETF and place a buy/sell spread around the fair value.

BetaShares works with a number of Market Makers. This seeks to ensure that investors can purchase ETF units during the trading day and, where there is more than one Market Maker making markets on an ETF, competition between the market makers also assists in maintaining a tight spread.

Summary

In summary, the presence of the Primary and Secondary markets ensure that even if there is not a high level of volume visible on the exchange at any one time, an ETF should generally remain as liquid as the securities it holds.

For more information on ETF liquidity, read our preceding blog article, and our “Understanding ETFs” FAQs.

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