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Posted by on Jan 21, 2016 in AdvisorShares, ETF Education

ETF Mechanics and Liquidity

ETF Mechanics and Liquidity

By Rob Parker, CFA, Director of Capital Markets

When a stock or a bond is traded, the traded price is the value of the security.  This is due to the fact that stocks and bonds are non-derivative securities.  Their value is driven solely by supply and demand at the moment of the trade.1  The supply of the security is fixed.2

There exists a whole array of derivatives in the marketplace, such as futures, options, and exchange-traded products (ETPs).  One such ETP of note is a closed-end fund (CEF).  In this structure, the issuer creates a static amount of shares that are traded on an exchange.  This unique structure can lead to differences between price and value (discount or premium).  Because CEFs are derivatives, their value is easily calculated by summing the values of the underlying holdings.  However, they are subject to their own demand paired with an inelastic supply.

Moving further along the spectrum are exchange-traded funds (ETFs).  Like CEFs, the value of an ETF is easily quantified.  They differ, however, in that the supply of ETF shares is elastic.  ETF shares can be instantly created or redeemed by Authorized Participants (APs).3  When demand for the ETF goes up in excess of the supply/demand curve of the underlying, the ETF will trade at a premium.  When this happens, APs will sell the ETF and simultaneously buy the underlying holdings (or a proxy of the underlying).  APs will then enter a create order with the ETF Sponsor whereby they receive shares of the ETF and deliver to the Sponsor the underlying securities or cash.  The inverse of the above scenario occurs when ETF demand recedes.

Delving deeper into the actual mechanics of ETF arbitrage can add some insights.  Focusing solely on the AP who hedges their ETF position with the underlying holdings, it becomes apparent that liquidity in the ETF is matched by liquidity in the underlying holdings.  The price and size at which an AP is willing buy (sell) an ETF is directly related to the price and size of the bids (offers) for the underlying plus any costs associated with the entire transaction.  The benefit to ETF investors comes when trading an ETF with low volume and slightly wider spreads.  As long as the underlying holdings have decent liquidity and the ETF trade is of meaningful size, the trade can usually be done directly with an AP.  The price received may be done inside the prevailing bid and offer.  This is a double-edged sword, however.  If the underlying holdings experience a bout of illiquidity, the ETF price will likely begin to trade erratically.  Understanding that illiquidity is not just the lack of interest in trading a security, but can also include a lack of a healthy two-sided market for a security.  We saw this in the flash crash when the stock prices of large-cap companies with stable businesses selling household products and services traded significantly lower.  There were several instances of companies that normally trade in the $40-$50 range that were temporarily trading for pennies until order was restored.  When everyone is headed the same direction, prices can seem very illiquid.

The aforementioned ETF arbitrage mechanism prevails in normal market conditions—normal in both the ETF and the underlying holdings.  There are, however, certain instances where ETFs can take on some of the characteristics of a stock or a CEF.  Interestingly, several different bond ETFs exhibit examples of both.

Several ETFs hold bonds that do not trade for days or weeks at a time.  Liquidity may be there on these bonds, but their dollar notional traded is very low to nonexistent.  The ETF itself, however, can trade several times higher in dollar notional.  In this instance, the ETF is taking on the characteristics of a stock.  The supply and demand of the ETF is leading to the price discovery of the underlying bonds.  The tail is wagging the dog.

As another example, some bond ETFs exhibit structural frictions in the create/redeem process.4 This can be driven by high create/redeem fees, cost of executing the underlying, the underlying trading with wide spreads/small size, difficulty executing the underlying, etc.  Anything that inhibits the APs from a “clean” arbitrage will introduce friction.  The effect is that these ETFs will begin to trade somewhat like their CEF cousins.  That is, if there are more ETF sellers than buyers, the ETF can and will trade at a discount to the underlying value.  The inverse would cause the ETF to trade at a premium.

In practice, meaningful pricing discrepancies have a low probability of adversely impacting longer-term investors.  That is not to say that Advisors or investors should not be cognizant of any discrepancies and the reasons for it.  Further to this point, investing in an ETF is a proxy for investing in the underlying holdings.  As such, the investor is receiving not only the returns embedded in the underlying, but all of the other portfolio characteristics including liquidity.
1 Some would argue that they endeavor to buy “undervalued” securities and sell “overvalued” securities.  Their concept of value may be looking at future value.  There might also be some transient, micro-structure issues that can make a security trade slightly away from where it otherwise would.  These and other issues are beyond the scope of this writing.

2 Granted, the issuer can issue or buy back shares or debt.  However, this is not done in a direct response to changes in demand for the shares/debt.

3 Authorized Participants are those who are legally able to create and redeem shares with the Sponsor.  Market Makers also trade ETFs on exchange, but must create and redeem through an AP.  For purposes of the writing, I will use the term AP to include APs, Market Makers, Arbitrageurs, etc.

4 Note that this is not limited to bond ETFs.  International ETFs are another example.  They tend to take on characteristics of both stocks (price discovery) and CEFs (ongoing structural frictions in the create/redeem process).

The AlphaBaskets blog provides frequent market insight and commentary by AdvisorShares Investments, LLC, created by AdvisorShares and other leading active managers.  AdvisorShares Investments is an SEC-registered investment adviser and the investment adviser to the AdvisorShares actively managed ETFs. The views expressed on AlphaBaskets should not be taken as investment advice or a recommendation for any of the actively managed ETFs advised by AdvisorShares.