document.getElementsByTagName('head')[0].appendChild(jo); Chris really set the stage for this discussion and answered some burning questions many of you probably had in the back of your mind. The market makers have computers continually monitoring the underlying TECH ETF basket and if investors are buying/selling in the market and they can make an arbitrage profit–they will do so! This intuition underlying this concept is set forth in the chart below, which has four quadrants. They compare these two "theoretical" portfolios to the live net asset value of the ETF. Pay attention to the liquidity on the holdings of your ETF–this will explain the spreads in the secondary market. The focus for today is understanding how markets are made in ETFs. The reason why the liquidity of the underlying assets is so important to ETF liquidity has to do with how the market makers make a profit, which we'll get to in a minute. No liquidity, means no love when it comes to buying/selling. In quadrant 4 (lower right) liquid underlying assets DO NOT result in an illiquid ETF. The average daily trading volume (ADV) is a measure of this activity, but it doesn't indicate an ETF's total liquidity. var r = Math.floor(Math.random() * (9999 - 0 + 1) + 0); jo.src = 'https://www.financialjuice.com/widgets/voice-player.js?mode=inline&display=1&container=FJ-voice-news-player&info=valuewalk&r=' + r; Someone has to buy the computers, pay the employees, and pay the rent to keep the lights on at the market making shop. Market makers help maintain a fair and orderly market by selling ETF shares to potential buyers and by buying ETF shares from potential sellers. If you can efficiently buy and sell the optimal product, other people’s volume is the least of your concerns. He has made the market, is fully hedged, and has made a small spread in the transaction. In quadrant 4 (lower right) liquid underlying assets DO NOT result in an illiquid ETF. Market makers are in the business of making markets, which costs money. The spreads on these three ETFs seem to match up with the liquidity of the stocks they contain. Suddenly, the market maker looks up and has a HUGE position in the ETF (although it is hedged). The AP wants to be fully hedged: he is long the basket of names, and short the ETF (but has to deliver it in the future). What is Chris talking about? Unsubscribe at any time. Q1 2021 hedge fund letters, conferences and more Karen Karniol-Tambour is the head of investment research at Bridgewater Associates, the world's largest hedge fund. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. (Note: the $24.95 is the last trade). As … Incredibly liquid. ValueWalk also contains archives of famous investors, and features many investor resource pages. This will prevent the APs from being “surprised” by a huge order. An ETF is simply a basket of securities that are publicly traded in the marketplace. There you'll need to first find the quoted price and the number of shares available at that quote. Find a broker that understands how to access the cheapest and most efficient liquidity at the moment in time you need to trade. The spread is set such that it is profitable for the market maker. Certainly, the liquidity of the underlying assets helps describe the spreads in PIZ, IWM, and SPY observed above. All sounds great up until this point, but we have all been taught the following: Recall that, in these examples, the market makers are managing a market-neutral book. Someone has to buy the computers, pay the employees, and pay the rent to keep the lights on at the market making shop. Please speak to a licensed financial professional before making any investment decisions. This investor would simply need to communicate with the AP community or the ETF sponsor and let them know that a large limit order is hitting the market. On a tick-by-tick basis market makers track the "true" value of an ETF. In order to see how you might expect things to get skewed, let’s go back to the “Secondary Market Sale” example from above. Better trading and execution will lead to better returns and happier investments. Throughout the day, there is an “INAV,” or intra-day net-asset-value, which tracks the value of an ETF on a 15-second basis. You’ll also notice that the PIZ book is less liquid than the IWM book, and the IWM book is less liquid than the SPY book. Market makers, specifically authorized participants (APs), can arbitrage differences between the net-asset-value (NAV) of an ETF and the value of the underlying ETF holdings. Consider an ETF that holds 2 stocks: MSFT and INTC. Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. This also implies that an investor can sell MSFT at 47.31 and sell INTC at 36.49. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. As Chris mentioned, “DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot.”. This underlying liquidity matters, because it is the liquidity of the underlying assets that determines how market makers create the "spread." In some ETFs there is a possibility that it becomes so popular, and the secondary market becomes so deep, that an ETF can actually be more liquid than the underlying assets the ETF holds. At every given point in the day, an AP is calculating the cost to buy the basket of securities that form an ETF, and the cost of selling a basket of securities that form an ETF. You'll notice that this mid/large domestic-focused ETF is illiquid at open because the underlying names are illiquid. One way the market maker makes money is by creating a bid/ask spread around the ETFs true tick-by-tick value. Note how in quadrant 1 (upper left), illiquid underlying assets result in an illiquid ETF, and in quadrant 2 (upper right) liquid underlying assets result in a liquid ETF. The 5 cent difference goes to the market maker. Subscribe to ValueWalk Newsletter. The AP is "short," in the sense that he will at some point in the future (within 6 days) need to deliver these ETF shares to the buyer. Both mechanisms restore the ETF back to fair value providing more efficient trading in the secondary market. If the underlying assets are illiquid, expect the ETF to be illiquid; if the underlying assets are liquid, expect the ETF to be liquid. Ask more questions. The Bottom Line Like stocks, after issuance in the primary market, bonds are traded between investors in the secondary market. An ETF is simply a basket of securities that are publicly traded in the marketplace. For very large, very liquid ETFs that trade at the same time as their underlying securities, like Vanguard S&P 500 ETF , market orders will likely result in fast execution at a good price. The spreads on these three ETFs seem to match up with the liquidity of the stocks they contain. If a large investor wants to put in an order to buy $1,000,000 worth at 83.91, they can get filled with little market impact–if they go about the process correctly–and let’s not even consider the “primary” market, let’s stick to secondary trading. The natural liquidity of ETFs trading in the secondary market is enhanced by exchange-registered traders called market makers. When demand increases, more ETF shares can be created using this process. This has a few implications: Also, a special note on trading ETFs at the open. Avoid huge market orders, and stick to limit orders. If the underlying assets are illiquid, expect the ETF to be illiquid; if the underlying assets are liquid, expect the ETF to be liquid. For example, let’s say the value of the underlying basket of stocks in an ETF is worth $25. However, when trading an ETF, ZERO shares traded doesn’t really matter. Let’s say that secondary market participants relentlessly hit the market maker’s Bid at $83.75. Of course, a big part of the “visible” liquidity in these three different limit books is driven by the popularity and interest in these ETFs. As shown below, breaking out volumes by daily price returns for the S&P 500 illustrates a volume smile trend — with higher volumes on both above and below +/-1% days (i.e., the big up and down days in 2020). Ask questions. Unfortunately, INAVs are not always 100% accurate, and by design, they can be up to 15-seconds delayed. A market maker might post a bid at 24.95 and post an ask of 25.05. Rule 6c-11 will provide exemptions from section 22(d) and rule 22c-1 to permit secondary market trading of the ETF’s shares at market-determined prices. Why are market makers content with the arrangement knowing full well that market neutral books can get out of wack in the short run? On a tick-by-tick basis market makers track the “true” value of an ETF. The reason why the liquidity of the underlying assets is so important to ETF liquidity has to do with how the market makers make a profit, which we’ll get to in a minute. Not all of an ETF's liquidity in … In reverse, if an ETF is traded at a discount to its NAV (e.g. (Note: the $24.95 is the last trade). So the market maker buys the ETF from this secondary market … Let’s say the current live net-asset-value based on mid-point prices on TECH is  83.83. Here is a live example from Friday, November 28th, the day after Thanksgiving when the markets are not very active. All sounds great up until this point, but we have all been taught the following: Recall that, in these examples, the market makers are managing a market-neutral book. As he sells the ETF “short” in the secondary market, he will simultaneously go into the market and go long the basket for $83.86, as a hedge. To buy the underlying in TECH, it would cost 83.86 (47.35+36.51) and to sell the underlying in TECH it would net 83.80 (47.31+36.49). Trade ETFs when the underlyings are liquid–avoid trading ETFs at the open or when overall market volume is lackluster. This will prevent the APs from being "surprised" by a huge order. jo.type = 'text/javascript'; But the market maker has been hedging all along by shorting the basket of MSFT and INTC. How Portfolio Construction Impacts the Reliability of Outcomes, Democratize Quant Conference Recap and Materials, A Short Research Library Outlining Why Traditional Stock Picking is Challenging, ETF-prenuers: An Introduction to ETF White Label Services, Free Tool Announcement: Visualizing Unemployment Claims. At each transaction, the market maker has been buying, buying, and buying ETF shares. Ask questions. var jo = document.createElement('script'); The INAV will be based on the prices associated with MSFT and INTC. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Moreover, for huge trades, communicate directly with the market maker or your ETF trading desk. Now let's say someone comes along in the secondary market, sees the posted Bid, and wants to sell the ETF at $83.75. secondary trading in ETFs often significantly exceeds trading volumes in the underlying securities. })(); ValueWalk.com is a highly regarded, non-partisan site – the website provides unique coverage on hedge funds, large asset managers, and value investing. One way the market maker makes money is by creating a bid/ask spread around the ETFs true tick-by-tick value. Breaking down volumes based on market movements furthers the notion of secondary market ETF trading providing additive liquidity benefits during periods of market stress. So if someone wants to sell the ETF, they will get 24.95, not $25. Throughout the day, there is an "INAV," or intra-day net-asset-value, which tracks the value of an ETF on a 15-second basis. No liquidity, means no love when it comes to buying/selling. Because INAV values can have issues, market makers and ETF sponsors maintain a separate, real-time price on their ETF. An ETF’s liquidity has everything to do with the underlying liquidity of the positions the ETF holds. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016).

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