ETF Liquidity and Replication

The basics of ETF trading is reviewed here.

An ETF is an investment fund traded on stock exchange or other trading facility much like a common stock. ETFs are issued by an ETF provider to an authorized participant (AP) [1] which then facilitates trading as market makers to the public. The liquidity of an ETF is determined by multiple factors, such as the method which the ETF provider is using for replicating the benchmark, what time zones the ETF is covering, and in relation to that at what time of the day the ETF is traded.

Time zone issues

The best liquidity measured by volume and bid/ask spreads is often seen in the largest benchmarks covering instruments within the same time zone. For ETFs tracking a global benchmark the problem with time zones arises. US financial assets are typically around 50 % of the market value of global benchmarks and thus trading in these global ETFs takes place in the afternoon in Europe to ensure access to the largest exposure of the primary market in the underlying benchmark. This means that market makers have inventory risk on the Asian instruments in the global benchmark. While most of the risk can be hedged the hedge is not perfect and thus spreads are wider.

ETF order execution

Trading volume is typically larger around the open and close in single stocks and thus trading is often carried out in those time periods. However, this is not the case for ETFs. Around 15-30 minutes after the open and before the close the pricing is typically worse [2]. In the beginning of the trading session ETF market makers need good quotes on all the underlying instruments in the basket to price the ETF with greater certainty. In the end of the trading session many ETF books are being hedged and spreads are typically widened. The general recommendation in ETF trading is to use limit orders.

Replication

ETFs can replicate the underlying benchmarks in two ways:

• Physical replication which means that the ETF owns the underlying physical assets
• Synthetic replication which means that the ETF provider enters into a total return swap with a financial intermediary

As a result of counterparty risk and other related risks many ETFs using synthetic replication have moved to a physical replication. Within the physical replication method, two implementation strategies exist:

• Full replication, which means that the ETF tracks the underlying benchmark as precisely as possible. The tracking error and the total expense ratio (the fee taken by the ETF provider) are often lower than ETFs using optimisation as trading only occurs when the underlying benchmark index changes.

• Optimisation, which means that the ETF tracks a subset of the underlying benchmark that provide the most representative sample of the index based on correlations, exposure and risk.

Optimisation is often used to enhance the implied liquidity in the ETF as the least liquid security in a benchmark index, adjusted for the benchmark weight, becomes the most constraining factor on underlying liquidity in the benchmark.

A deep-dive into the the ETF market mechanisms

The ETF market consists of three layers of liquidity: exchange, OTC (over-the-counter) and underlying benchmark liquidity. Exchange and OTC are called the secondary market, and the underlying liquidity in the index is called the primary market liquidity. As the exchange layer has minimal liquidity in many European ETFs, the OTC trading and create/redeem mechanism are important liquidity pools for institutional investors. All flow in larger sizes will tap into the hidden liquidity in the OTC market and the underlying instruments.

Exchange liquidity

The exchange liquidity is the natural flow between buyers and sellers, and typically an ETF is traded on multiple exchanges as with stocks. In Europe many ETFs have multiple listings while in the US an ETF typically only has one exchange listing. In recent years the ETF volume has risen dramatically above average levels during small corrections indicating that ETFs are increasingly used by investors as the first layer of liquidity when adjusting portfolio exposure.

OTC liquidity

In the initial phase, the ETF market liquidity was less of a concern as the market was dominated by retail investors and the institutional money committed to ETFs was minimal. In the last five years, institutional investors have increasingly adopted ETFs in their trading strategies. But trading in less liquid ETFs can cause potential price impact and slippage creating a real concern for institutional investors committed to deliver best execution for their clients.

As a result, trading platforms and market makers have created a secondary market structure to the normal order book on the exchange called Request for Quote (RFQ). In RFQ a request is made in a closed system of market participants, where all quotes from interested participants are collected. The order is not displayed and thus not visible allowing for better execution price for large orders, allowing the necessary flexibility for institutional investors and market makers.

Underlying benchmark liquidity

The most important part of the ETF ecosystem is the ETF create/redeem mechanism which links the secondary market with the underlying primary market. The creation/redemption mechanism effectively ensures a tight link between the ETF and the underlying benchmark liquidity. This additional layer of liquidity in the primary market is facilitated by authorized participants who ensure well-functioning ETF markets by balancing the supply and demand of ETFs.

If demand increases for an ETF above the available supply in the exchange market the AP will buy the basket of the securities underlying the index in the primary market. The AP delivers the shares to the ETF provider and receives in exchange newly created ETF units which are then sold to investors in the secondary market (see figure below). The opposite takes place if selling exceeds demand from investors by the redeem mechanism. Every time an AP uses the create/redeem mechanism it earns an arbitrage profit. Competition between APs ensures tight bid/ask spreads, and the spread is often the best indicator of the liquidity of an ETF. The create/redeem mechanism ensures the price of an ETF is in line with its underlying net asset value (NAV). Creation and redemption of ETF shares takes place overnight with the ETF provider.