{"id":38272,"date":"2014-11-19T03:02:13","date_gmt":"2014-11-19T02:02:13","guid":{"rendered":"http:\/\/beta.next-finance.net\/strategie\/etf-liquidity-a-vital-measure-of-efficiency\/"},"modified":"2019-12-30T23:12:09","modified_gmt":"2019-12-30T22:12:09","slug":"etf-liquidity-a-vital-measure-of-efficiency","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/strategie\/etf-liquidity-a-vital-measure-of-efficiency\/","title":{"rendered":"ETF Liquidity: A vital measure of efficiency"},"content":{"rendered":"

What does the liquidity of an ETF mean?<\/strong><\/p>\n

In simple terms, the liquidity of an ETF is the ability of the fund to meet
\ninvestors\u2019 buying and selling orders without a significant impact on its
\nprice. This liquidity reflects a number of factors, primarily the liquidity of the
\nunderlying market, but it also reflects structural features of the ETF.<\/p>\n

The secondary market price of an ETF is set freely by market participants
\nbased on price moves in the underlying securities. The highest buying order
\nfor a fund (best bid) and the lowest selling order (best offer) set the ETF\u2019s bidoffer spread. The depth of an ETF\u2019s order book shows the capacity of the
\nmarket to absorb larger transactions.<\/p>\n

In Europe, a significant part of ETF trading takes place away from exchanges
\nin the bilateral, over-the-counter (OTC) market. OTC market orders also
\ncontribute to the liquidity of an ETF.<\/p>\n

What\u2019s the difference between the liquidity of an ETF, an ordinary share and a traditional fund?<\/strong><\/p>\n

An ETF is a hybrid between an ordinary share and a traditional fund. Both
\nETFs and ordinary shares are traded on stock exchanges throughout the
\nday; by contrast, a traditional mutual fund usually has a single daily entry\/exit point for investors wishing to buy or sell. But an ETF\u2019s share capital, like that of a traditional fund, is variable (open-ended), whereas the share capital of a company does not vary in response to market supply and demand. This feature means that supply and demand is less relevant for ETF pricing than moves in the price of the underlying securities.<\/p>\n

Why does an ETF \u2019s liquidity matter for investors?<\/strong><\/p>\n

ETFs\u2019 ability to offer investors low-cost and flexible exposure to a variety of
\nasset classes is the key reason for their popularity. Part of ETFs\u2019 low-cost
\npromise is that their average fund expenses are usually lower than those of
\ncomparable actively managed funds. But the cost to enter and exit an ETF
\nis also frequently lower than that of a traditional fund. The ability to transact
\nin ETF shares at the time of their choosing and at relatively low cost is very
\nattractive for investors.<\/p>\n

From where is an ETF \u2019s liquidity sourced?<\/strong><\/p>\n

The liquidity of an ETF is sourced from both the primary
\nand secondary markets. In the primary market, specialised
\nintermediaries called \u201cauthorised participants\u201d or \u201cAPs\u201d
\ntransact directly with the ETF issuer to \u00abcreate\u00bb and
\n\u00abredeem\u00bb ETF shares: new ETF shares are issued if
\ndemand is high or existing shares are withdrawn if there is
\ntoo much supply.<\/p>\n

The secondary market is where continuous trading in ETF
\nshares occurs. Secondary market transactions can be in
\nany number of ETF shares.<\/p>\n

The primary and secondary markets of an ETF are linked.
\nA liquid secondary market in an ETF\u2019s shares depends to
\na great extent on an efficient primary market mechanism.
\nLyxor is constantly working on its primary market setup to
\nmake sure it is as supportive of liquidity as possible.<\/p>\n

What can an ETF issuer do to influence the liquidity of its funds?<\/strong><\/p>\n

Although an ETF issuer has no direct impact on the
\nsecondary market liquidity of its funds, it can influence
\na fund\u2019s liquidity positively by putting in place a robust,
\ndiversified and flexible primary market structure.
\n
Lyxor does this in three ways. First, we operate an open
\naccess model, contracting with over 50 APs to create
\nand redeem units in Lyxor ETFs. Second, we offer APs an
\nefficient creation\/redemption process, with creation and
\nredemption fees that reflect the actual cost of trading the
\nunderlying securities, a low minimum creation size and
\nflexibility in terms of the assets that the AP may offer in
\nexchange for the ETF units (for example cash, futures or
\nan index basket). Third, over 15 official liquidity providers
\nquote continuous bid and offer prices on exchanges
\nthroughout Europe, bringing liquidity to the order book of
\nLyxor ETFs.
\n
Together, these measures have made Lyxor\u2019s ETFs among
\nthe most highly traded in Europe.<\/p>\n

What is an ETF \u2019s \u201cfair value band\u201d?<\/strong><\/p>\n

The secondary market price of an ETF typically fluctuates
\nfreely within a so-called \u201cfair value band\u201d around the fund\u2019s
\nindicative net asset value (iNAV). The iNAV measures the
\nfair value of an ETF share during continuous trading.<\/p>\n

\"how_an_etf_s_price_fluctuates_around_inav-2.jpg\"<\/p>\n

The fair value band reflects the cost to the AP of
\ncreating and redeeming fund units. For example, when
\naccumulating the shares to place a creation in an equity
\nETF, the AP will pay what we call arbitrage costs: part of
\nthe bid-offer spread on the underlying shares, plus any
\napplicable commissions and taxes. The upper limit of the
\nfair value band exceeds the ETF\u2019s iNAV by a margin that
\nreflects these creation costs. Similarly, the lower limit of the
\nfair value band reflects redemption costs.<\/p>\n

What happens if transaction taxes are payable on the underlying securities?<\/strong><\/p>\n

If transaction taxes are payable on purchases of the
\nsecurities that make up the ETF\u2019s creation basket, the
\nupper limit of the ETF\u2019s fair value band will reflect the cost
\nof paying those taxes.<\/p>\n

For example, an ETF owning UK shares will have a fair value
\nband that reflects the 50 basis point (0.5%) stamp duty
\nreserve tax (SDRT) payable on purchases of UK shares.
\nLyxor\u2019s ETFs tracking UK share indices typically own other
\nEuropean shares, together with a performance swap,
\nunder which a counterparty promises to pay the return on
\nthe index. This means that creation costs in a Lyxor ETF
\ntracking a UK share index are relatively lower than in a fund
\nthat owns UK shares directly.<\/p>\n

In the chart we show the price deviations from NAV over
\ntime of two ETFs tracking the FTSE 100 index. One ETF\u2019s
\nprice trades at a frequent premium to NAV, reflecting the
\n0.5% SDRT. The price of the Lyxor ETF stays much closer
\nto NAV.<\/p>\n

\"price_deviation_from_nav_-_premiums_discounts_on_two_ftse_100_etfs-2.jpg\"<\/p>\n

Why is the secondary market bid-offer spread of an ETF often lower than
\nthe average spread on the underlying securities?<\/strong><\/p>\n

The liquidity of an ETF consists of two layers: the first one
\nis the liquidity of the underlying securities, and the second
\nis the intrinsic liquidity of the ETF itself. As we explained
\nearlier, the secondary market bid-offer spread of an ETF
\nis set by the interactions of the many investors, traders
\nand arbitrageurs placing buying and selling orders. As a
\nresult of this interaction of buying and selling demand, an
\nETF\u2019s secondary market bid-offer spread is often narrower
\nthan the average spread payable on the full basket of index
\nsecurities.<\/p>\n

For example, whereas a typical bid-offer spread in a
\ncorporate bond may be a percent of the bond\u2019s notional
\nvalue, the spread of a corporate bond ETF may be a few
\nbasis points (hundredths of a percent).<\/p>\n

Narrow ETF secondary market spreads reflect the inherent
\nefficiency of a pooled investment vehicle with a diverse
\nbase of investors and traders. However, it\u2019s important to
\nremember that, by contrast with a traditional fund, which
\nusually has a fixed spread between buying and selling
\nprices, an ETF\u2019s spread is variable. And in stressed market
\nconditions spreads may widen to reflect the full cost of
\ntrading the underlying index basket.<\/p>\n

Why is the full liquidity of an ETF sometimes \u201cinvisible\u201d?<\/strong><\/p>\n

Not all of the latent demand to buy or sell ETF shares is
\ndisplayed on stock exchanges\u2019 order books. Partly, this
\nreflects the fragmentation of exchanges and other trading
\nvenues in Europe \u2013 meaning that liquidity is split between
\nthe multiple listings of the same ETF. But the widespread
\npractice of trading ETFs in the OTC market also leads to a
\ngeneral underreporting of trading volumes.<\/p>\n

The liquidity of an ETF is based on the liquidity of the fund\u2019s
\nunderlying securities. Not all that underlying liquidity may
\nbe shown in the ETF\u2019s own reported trading volumes. As
\na result of this hidden liquidity, it may be possible to place
\nan order that seems large by comparison with reported
\nvolumes, without having a significant impact on the ETF\u2019s
\nprice. Investors should remember that this hidden liquidity
\nexists.<\/p>\n

How can liquidity be measured?<\/strong><\/p>\n

The best objective measure of an ETF\u2019s liquidity is the data
\npublished by Europe\u2019s stock exchanges.<\/p>\n

However, given the fact that part of an ETF\u2019s liquidity
\nmay be hidden, transaction cost analyses can also be
\nbased on the ETFs\u2019 underlying securities. Many market intermediaries provide such analyses and Lyxor\u2019s capital
\nmarkets team can also help investors assess an ETF\u2019s
\nfundamental liquidity.<\/p>\n

Do competing ETF s on the same index have the same bid-offer spreads?<\/strong><\/p>\n

Not necessarily. ETFs from competing issuers that track
\nthe same index can have different bid-offer spreads for a
\nvariety of reasons: more or less efficient primary market
\nstructures; differences in the number of market makers
\nactive in a particular fund; and differences in fund size.
\nOther things being equal, a larger fund tends to attract
\nmore trading volume, leading to lower spreads, in a
\nvirtuous circle effect.<\/p>\n

The chart below, which shows 5-day moving average bidoffer
\nspreads on three European ETFs tracking the MSCI
\nWorld index, illustrates that such differences exist.<\/p>\n

\"spreads_on_msci_world_etfs_-_lyxor_ishares_source-2.jpg\"<\/p>\n

How will regulatory changes affect European ETF market liquidity?<\/strong><\/p>\n

We expect ongoing regulatory changes to have a positive
\neffect on the ETF market\u2019s liquidity.<\/p>\n

Currently, for example, the reporting of OTC transactions
\nin ETFs is voluntary in many European markets. However,
\nunder the second version of the Markets in Financial
\nInstruments Directive (MiFID II), which was passed in April
\n2014, a \u201cconsolidated tape\u201d of trades in shares, depositary
\nreceipts, ETFs, certificates and other similar financial
\ninstruments is due to be introduced by the end of 2016.
\nThe consolidated tape will be available free of charge 15
\nminutes after its publication. All ETF trades, including the
\nones conducted OTC, will therefore be visible. This added
\ntransparency will show the true liquidity of ETFs.<\/p>\n

Another regulation, the Central Securities Depositary
\nRegulation (CSDR), is due to harmonise settlement and
\nbuy-in rules across Europe\u2019s exchanges and settlement
\nsystems. This should also help to reduce the current
\nmarket fragmentation in Europe.<\/p>\n

How does ETF liquidity impact Lyxor\u2019s efficiency measure?<\/strong><\/p>\n

Liquidity is a key part of Lyxor\u2019s framework for evaluating
\nthe efficiency of an ETF. An ETF\u2019s secondary market
\nliquidity, measured as its exchange-based bid-offer
\nspread, is one of the three factors contributing to any ETF\u2019s
\nefficiency score. The wider the spread of an ETF, the lower
\nits efficiency score.<\/p>\n

The other two factors contributing to the efficiency score
\nare an ETF\u2019s performance and its tracking error.<\/p>\n

From where can an investor obtain advice about the best ways of executing ETF trades?<\/strong><\/p>\n

Many market makers and broking firms now have specialist
\nETF advisory units, who can offer advice on the best way
\nto execute ETF trades: for example, how best to time
\ntrades to source times of peak liquidity in the underlying
\nmarket, whether to place a market or limit order or to
\ntrade by means of an algorithm. It\u2019s worth developing
\nrelationships with a few trusted counterparties from this
\ngroup of intermediaries.<\/p>\n

Although Lyxor\u2019s ETF capital markets team does not buy
\nand sell ETFs, we are there to offer objective guidance to
\ninvestors wishing to source ETF liquidity. We can often help
\nunearth market inventories or demand, enabling clients to
\nreduce execution costs. We encourage anyone to pick up
\nthe phone and get in touch!<\/quote>
\n