In January 1993, the SPDR S&P 500 ETF (SPY) became the first Exchange Traded Fund (ETF) to list in the United States. By the end of the decade, SPY, according to Morningstar as of 1 January 2003, had gathered nearly $40B in assets, traded approximately $3.9B per day, and was joined by 74 other ETFs in the marketplace. Fast forward to today, SPY, according to Morningstar as of 31 December 2019, now has more than $300B in assets, trades over $19B per day, and is one of over 2,400 ETFs in the $4.5 trillion US ETF market.
According to Bloomberg, as of 31 December 2019, over the last 5 years, ETFs have grown at a compounded annual rate of approximately 17% as investors continue to capitalize on what many perceive to be the transparent and tax-efficient nature of exchange traded funds. Trading volume has also grown alongside assets, as ETFs now trade approximately $90B per day, which represents approximately 26% of all trading volume in the US according to Bloomberg, as of 31 December 2019.
As seen in the chart below, according to ETF.com, while the ETF industry saw a wave of product growth from 2002-2015, growth in the number of ETFs listed in the US has slowed over the past five years. As the industry has matured, product development continues to impact investors through both the introduction and closure of new ETFs.
Despite the growth and maturation, however, ETFs are still relatively new compared to other investment vehicles. Being exchange traded, they also differ from mutual funds and investors may want to understand aspects of their structure and how they interact in the capital markets. In the sections that follow, this guide will lay out the conceptual foundation for readers to comprehend these key features.
At the core of the ETF structure and considered by many investors as one of the benefits is the creation and redemption process. Just like a mutual fund, ETFs have the ability to increase or decrease the number of shares available on a daily basis. The process, however, looks very different.
When demand in a mutual fund triggers a creation of new shares, the portfolio management team will typically take investor cash, go into the marketplace, and purchase the desired securities that the portfolio managers want to add to the fund. When selling pressure triggers redemption of fund shares, the portfolio management team is tasked to go out into the market and sell securities to raise cash to meet the redemption.
Authorized participants are one of the major parties at the center of the ETF creation/ redemption mechanism, and as such, they play a critical role in ETF liquidity.
While many mutual funds manage tax efficiency well, this cash-driven creation and redemption mechanism may contribute to capital gains distributions if they occur.
ETF shares are typically created in large blocks and by entities referred to as Authorized Participants (AP). APs are large institutional liquidity providers that have a legal agreement in place with an ETF issuer that gives the AP the ability to expand or contract the number of ETF shares in the marketplace.In-Kind Creation and Redemption
When demand for an ETF triggers a creation of new shares, the in-kind creation method may be used. With an in-kind creation, APs will deliver a predetermined basket of securities to the ETF issuer, which are stored at the issuer’s custodial bank. In exchange for these securities, the ETF issuer will give the AP new ETF shares to distribute in the marketplace.
When selling pressure in an ETF triggers redemption of shares, the in-kind method may also be used. With an in-kind redemption, APs will go into the public marketplace and purchase available ETF shares, deliver them back to the ETF issuer, and in exchange for these shares, the ETF issuer will give the AP a predetermined basket of securities.
In essence, APs are ETF liquidity providers that have the right to change the supply of ETF shares in the market. When they spot a shortage of ETF shares in the market, they create more shares. Conversely, when there’s an excess supply of ETF shares in the market, they reduce the number of shares by way of the redemption mechanism.
While not the only factor helping the ETF to be tax efficient, the in-kind creation and redemption process is the backbone. The exchange is not considered a taxable event and therefore the ETF generally may not recognize a gain or loss.Cash Creation and Redemption
In-kind creation and redemptions are standard for much of the ETF universe; however, there are some that are handled via a cash process. With a cash creation, an AP will deliver cash to the issuer’s custodial bank in exchange for a creation unit of the ETF. With a cash redemption, the AP will deliver shares of the ETF to the custodial bank in exchange for an equivalent amount of cash. The standard process for every ETF will be detailed in the fund’s prospectus.
Creation and Redemption Baskets
An ETF liquidity provider is a firm that helps facilitate the purchase or sale of an ETF. Liquidity providers are typically compensated through the difference between the bid and ask price (often referred to as the “spread”) of the ETF or by a commission. A liquidity provider may be a market maker, an authorized participant, and in some cases both. There are also market makers that are not authorized participants, but instead utilize another firm that is licensed as an AP.
Except for issuers of non-transparent ETFs, each day ETF issuers are required to publish an ETFs current holdings along with a creation and redemption basket file. The basket file informs various market participants some that are referred to as “liquidity providers” what securities will need to be delivered for a creation unit and what securities will be received for a redemption unit. Using a partial creation basket as of 7 January 2020, for the FlexShares Quality Dividend Index Fund (QDF), the list below shows some of the names of securities that would need to be delivered for a creation.
It is important to note that not every investor’s buy or sell order may trigger a creation or redemption of shares. Liquidity providers may sell ETF shares from inventory or sell shares short to an investor and hedge their exposure until they accumulate the required amount of shares for a creation unit. They may also hold ETF shares on their balance sheet and hedge exposure until they accumulate enough shares for a redemption unit. This will be discussed in greater detail in the “ETF Liquidity” section, however, this dynamic is often a factor in the on-screen bid/ask spread of an ETF. If an ETF is thinly traded, a liquidity provider will need to factor these carrying costs into their price.
Just as an ETF issuer is required to publish a daily creation and redemption basket for each ETF, they are also required to publish a net asset value and an intraday indicative value.
The computer screen shots within this Insight are taken from actual Bloomberg shots. Bloomberg terminals are predominately used by investment professionals and help to evaluate markets, individual securities and investment vehicles. These pictures are used only to demonstrate a particular point and are for illustrative purposes only and may be subject to change.ETF NAV & Fair Value
A fund’s NAV is the sum of all its assets (the value of its holdings in cash, shares, bonds, financial derivatives and other securities) less any liabilities, all divided by the number of shares outstanding. “Fair value” is a broad measure of what an asset is perceived to be worth based on an actionable price. The NAV of an ETF is published on a daily basis and is helpful in assessing performance over various time periods. It is important to note that because the NAV is only calculated at the end of the trading day based upon the closing price of each constituent in the basket, its intraday usefulness is limited and should not be used to determine the trading value. As the market opens and the underlying securities begin trading, the NAV could be considered stale. If the underlying securities within the portfolio rise, the ETF may appear to be trading at a premium to fair value and if the value of the portfolio falls, the ETF will appear to be trading at a discount to fair value. In reality, the NAV may simply be lagging as it is only updated at the end of the trading day.
The screen shots below, illustrate a historical example of an intraday disconnect for the FlexShares Quality Dividend Index Fund (QDF). As shown in the “Example of QDF NAV at the close” screen shot below, the closing NAV for QDF on 7 January 2020 and therefore, opening NAV on 8 January 2020 when the market opened, was $48.12. Yet when trading actually began, as shown in the “Example of QDF Intra-Day Bid & Ask” screen shot below, QDF had an asking price of $48.24 (bid price $48.23), a $0.12 premium to the NAV. While this may appear to be a disconnect from fair value, the NAV was simply not caught up with the price movement of the underlying securities as they appreciated in value that day.
For ETFs that contain securities trading outside of US market hours, it is also important to note the NAV may deviate even at the end of the day based upon differences in trading hours in different markets.The Intraday Indicative Value
To help address the potential limitations of an ETF’s NAV, ETF issuers are also required to publish an intraday indicative value (IIV). Similar to the NAV, the IIV calculates the value of the underlying portfolio; however, it is updated every fifteen seconds based on the last traded price of each security. For ETFs holding securities that trade frequently during US market hours, the IIV typically will be a better gauge of underlying value. However, when evaluating ETFs that hold international constituents or other securities that do not trade frequently during US market hours, the IIV’s usefulness may be limited.
For example, as seen in the “Example of NFRA Pricing” screen shot below, on 8 January, 2020, at 10:24 a.m. ET, the FlexShares STOXX® Global Broad Infrastructure Index Fund (NFRA), had an asking price of $53.71; however, as seen in the “Example of NFRA IIV” screen shot below, IIV at that time showed $53.5739.
While some investors may have felt that the NFRA offer price was disconnected from the fair value, many of the countries in which it had exposures (e.g., Japan, China) were closed. Consequently, the IIV was being calculated based upon the last traded price of each security in markets that had been subsequently closed. Investor assessments of value for some of those underlying securities, however, had changed and now the offer price for NFRA was actually a reflection of the prices of those underlying securities based on these new assessments of value.
This dynamic is also similar for fixed income ETFs where the underlying bonds may not be trading frequently. In summary, both the NAV and IIV are useful as long as investors understand each metric’s limitations.
Given the open-ended nature of ETFs discussed in the creation and redemption section, ETFs and their underlying baskets are fungible. At a basic level, the ETF is simply a wrapper that holds a basket of securities; therefore, there is an inherent arbitrage mechanism built into each fund. We believe this arbitrage mechanism is typically what keeps the ETF trading in line with true fair value.
Arbitrage is the simultaneous buying and selling of securities in different markets in order to take advantage of differing prices for the same asset.
If the ETF begins trading at a value that is higher than the value of the underlying basket, a liquidity provider would have the ability to sell the ETF high, buy the underlying securities and create new ETF shares, locking in an arbitrage profit.
If the ETF begins trading at a value that is lower than the value of the underlying securities, a liquidity provider would have the ability to buy ETF shares, sell the underlying basket and redeem the shares, locking in an arbitrage profit. This process theoretically would continue until the ETF price is driven back in line with the value of the underlying basket.
Due to this dynamic, ETFs typically trade within what is known as the “arbitrage bands” or in the “no-arbitrage zone”. As shown in the drawing below, this range is typically between the weighted average bid of the underlying securities (lower arbitrage band) and the weighted average offer of the underlying securities (upper arbitrage band), plus or minus other transaction costs (e.g., creation/redemption fees, stamp taxes, etc.), respectively.
This dynamic essentially incentivizes liquidity providers to accurately price an ETF at any given moment in time during the trading day. If their displayed bid or offer is either above or below the no arbitrage zone, other market participants may step in and capture an arbitrage profit at the liquidity provider’s expense.
While historically investors have not attempted to engage in these arbitrage opportunities, this dynamic is important to understand as it explains why the ETF’s price is not set based upon supply and demand, but rather based upon the value of the underlying securities. We believe that this has given investor’s confidence in the ETF structure, knowing that if an ETF temporarily rises or falls outside the bounds of the no arbitrage zone, the arbitrage mechanism is there to help bring the price back in line.
While ETFs trade on an exchange, many consider their liquidity profile to be unique. When examining the potential liquidity of an ETF, there are two factors that should be observed in conjunction with one another: primary market liquidity and secondary market liquidity.
Primary Market Liquidity
Given the open-ended nature of ETFs and the ability to create and redeem shares, we believe ETF liquidity cannot simply be measured by looking at the average daily volume. The underlying constituents of the ETF basket must also be taken into consideration, as they can be used to help facilitate a purchase or sale of shares.
If demand for an ETF is greater than the number of shares available in the market, a liquidity provider can purchase the underlying ETF basket, deliver the basket to the ETF issuer’s custodial bank, and in exchange obtain the ETF shares needed to satisfy market demand.
If selling pressure for an ETF builds, a liquidity provider can buy the ETF shares from investors, return them to the ETF issuer’s custodial bank, and in exchange receive back the underlying basket of securities.
Therefore, if an ETF’s underlying basket is considered liquid, the basket has historically translated into primary market liquidity for the ETF. The screen shots below show an example of this potential liquidity. On 17 October 2019, at 2:30 pm ET, an investor wanted to buy 235,000 shares of the FlexShares High Yield Value-Scored Bond Index Fund (HYGV). At the time of the trade, however, as shown in the “Example of Historical Average HYGV Volume” screen shot below, HYGV was only averaging 33,043 shares traded per day.
At first glance, there may not appear to be adequate liquidity to satisfy this order; however, as shown in the “Example of HYGV Quote Recap & Share Order Fill” screen shot below, at 2:30 pm CT on that day, the entire 235,000 share block was traded on the screen offer.
This sale was facilitated through HYGV’s primary market liquidity via the cash process previously discussed on page 4. As shown in the “Example of HYGV Shares Outstanding” screen shot below, HYGV’s shares outstanding increased by 150,000 shares to reflect a creation of new shares.
How to Measure Primary Market Liquidity
An ETF’s implied liquidity can be found using the ETFL<GO> function on Bloomberg.
As a general indication of an ETF’s primary market liquidity, investors may want to view an ETF’s “implied liquidity”. Implied liquidity provides an indication of how many shares potentially can be traded based on how liquid the underlying basket is at the moment.
Implied liquidity takes the least liquid constituent in the ETF basket and calculates how many ETF shares could potentially be traded and still remain under 25% of its average daily volume.
Implied liquidity is often used as a potential indication of primary market liquidity. The FlexShares ETF Capital Markets team is a team of experts that can help assess the ETF’s true liquidity.
The Potential Cost of Using Primary Market Liquidity
As previously mentioned, when ETF shares are created or redeemed, a liquidity provider will need to purchase or sell the underlying securities. For a primary market creation, the cost to an investor may reflect the liquidity provider’s cost to buy the basket plus any other potential expense. For a primary market redemption, the cost to an investor will reflect the liquidity provider’s cost to sell the basket plus any other potential expense.
Secondary Market Liquidity
In addition to primary market liquidity, ETFs are considered by some to be unique in that they have an additional liquidity outlet in the secondary market. Secondary market liquidity is the daily volume an ETF trades that does not trigger a creation or redemption of shares. It is simply the ETF changing hands on an exchange. As an ETF garners interest from various investors, natural buyers and natural sellers emerge, and orders may be satisfied on an exchange without the need for an AP to perform a creation or redemption.
Many mature ETFs such as the FlexShares Upstream Natural Resources Index Fund (GUNR) which according to Bloomberg as of 12/31/2019, have a high percentage of their volume that takes place in the secondary market. According to Bloomberg, as of 12/31/2019, GUNR traded over 500,000 shares per day in 2019, with 77% of this volume taking place in the secondary market (and thus not triggering a creation or redemption of shares).
Costs of Secondary Market Liquidity
Without the need to create or redeem shares, liquidity providers have the option to accumulate shares from and sell shares to other investors. This cost savings for the liquidity provider will often result in a tighter bid/ask spread. When flows are balanced with buyers and sellers, the ETF may also trade towards the middle of its arbitrage bands, reflecting a potentially lower overall transaction cost for the investor.
Spread is the percentage difference between the bid and offer price of a security.
While cost savings may be minimal for ETFs with very liquid baskets, it can potentially be magnified for ETFs holding less liquid securities, such as high yield corporate debt. A 2018 SEC study* showed that costs to trade individual high yield bonds can vary based on order size. The study demonstrated that larger sized orders of over $1 million usually referred to as Institutional Sized Orders, experienced a lower bid to offer spread. Individual investors with smaller sized orders of under $1 million experienced a higher bid to offer spread during that same time frame. This differential was still evident during the latter half of 2019 based on information gathered by Bloomberg and shown in the chart below.
Based on this dynamic, investors may benefit by being able to access high yield exposure at a lower bid to offer spread than they might be able to through investing in the actual high yield bonds. In fact, according to Bloomberg, as of 31 December 2019, HYGV traded at an average bid/ask spread of 0.13% in the second half of the year.
Pairing together the primary market and secondary market liquidity for an ETF may provide investors with a holistic view of its liquidity.
In July of 2002, nearly a decade after the first equity ETF was listed in the US; Barclays Global Investors launched the first series of US-listed fixed income ETFs. Today, fixed income ETFs are one of the fastest growing segments of the ETF marketplace, with assets according to Morningstar at the end of 2019 topping $820B (~19% of all US ETF assets).
Fixed income securities generally trade over the counter and with less transparency, than their equity counterparts. Some bonds may go hours, days, or even weeks without trading, making them more difficult to price. While these market structure dynamics do bring an added layer of complexity, they have also set the stage for ETFs to potentially help address some of the challenges bond investors face today. We believe that ETFs have helped increase price transparency and accessibility, while potentially reducing trading costs. With the convenience of a single equity-listed ticker, investors can now obtain diverse exposure to various areas within fixed income.
Fixed Income ETF Mechanics
The creation and redemption process for fixed income ETFs is slightly different from the process for equity ETFs. Given the larger increments many fixed income securities trade in, it would be inefficient to deliver all of the underlying securities in the portfolio or receive back all of the securities in the portfolio, as would happen with an equity-based ETF. Instead, based on the specifics written in the prospectus, the ETF may determine a subset of securities that will be received for a creation or given back for redemption and this is often referred to as a sampling approach.
According to Bloomberg, as of 31 December 2019, the cash creation and redemption process is very common with fixed income ETFs. As of the end of 2019, 69% of fixed income ETFs listed the cash process as the standard option for the creation or redemption process.
Given the trading frequency of the underlying bonds, fixed income ETFs may often act as a price discovery vehicle for the securities they hold. Liquidity providers are consistently posting actionable bids and offers for the ETF based upon their assessed value of the underlying portfolio of bonds.
Institutional adoption of ETFs has picked up in recent years, and according to FactSet, as of 31 December 2019, institutions now make up approximately 40% of aggregate US-listed ETF AUM.
Along with AUM growth, institutional investors have also expanded the ways in which they use ETFs. While according to Bloomberg, as of 31 December 2019, most ETFs are considered passive investing vehicles, they can be used as active tools by institutional portfolio managers for the purpose of strategic and tactical allocations, liquidity management, transition management, or as a way to replicate an active manager.
We believe ETFs are often prized for their liquidity, allowing investors to easily buy and sell a portfolio on an exchange. Given this dynamic, institutional portfolio managers may allocate a percentage of their portfolio to an ETF as a liquidity sleeve. As liquidity needs in a portfolio arise (e.g., client redemptions), instead of immediately selling out of securities within a portfolio, the portfolio manager may potentially utilize the ETF as a source of immediate liquidity. In our opinion, this may be viewed as building a layer of protection around a portfolio, as it may help mitigate the liquidation of a desired holding.
Cash Management & Manager Transitions
Similar to liquidity management, we believe many institutions take advantage of an ETF’s liquidity to help manage incoming cash. When new funds come into a portfolio, the portfolio manager may choose to immediately invest the funds into an ETF. This may allow the portfolio to be fully invested at all times. Similarly, if a manager transition is in process, the ETF can be used as an intermediary investment until the new manager search is complete.
While factor investing is not new, our research suggests that accessing factors with an ETF is. This new access may allow an investor to implement desired factor tilts in a portfolio and as factor ETFs have grown in popularity, many institutions may use them as a potential way to target exposures.
* Source: Securities & Exchange Commission. Published 29 July 2019 and covers 1 January 2018 to 31 December 2018. “Preliminary Recommendation Regarding Investor Education Around Secondary Market Liquidity in the Corporate Bond Market for Retail Notes.”
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The FlexShares approach to investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of any of the ETFs discussed in this Insight in greater depth or find out more about the index methodology behind them please don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383).