Demystifying Liquidity and Valuation of ETFs

By Gary Knight, Vice President Trading, CEO TMX Select

Toronto Stock Exchange now lists over 300 Exchange Traded Funds (ETFs) and has shown great momentum since cresting 200 funds on June 1, 2011. This growth is fueled by investor interest and eight innovative ETF providers that we're proud to count among our customers.

These ETF providers continue to develop a diverse array of products to meet the needs of investors. In this constantly evolving and fast-growing world of ETFs, there seems to be no shortage of information available. And yet, there is much that is still misunderstood by those who would count themselves as ETF savvy investors.

Two of the most basic concepts that apply to investing in traditional stocks are not wholly applicable to ETFs. What are these anomalies? Liquidity and intraday trading trends.

Hidden Liquidity

At first take, some may see an ETF as they do a stock, with its own distinct liquidity based on its trading activity. However, unlike stocks, ETFs have a secondary source of liquidity: their Designated Broker (DB). All ETFs have DBs that are responsible for the creation and redemption of ETF shares and they create or redeem shares in response to market demand. This is quite unique in the realm of equity securities. The equivalent with stocks would be if a company was able to issue and redeem their company's shares, at will, on each trading day.

When a client places a large buy order with a DB, the DB can short sell the ETF units. The DB immediately offsets this risk by purchasing the underlying stocks. This happens within a fraction of a second, using advanced technology to execute the trade directly on the exchange. At the end of the day, the DB is able to exchange the stocks for ETFs with the issuer. The DB then offsets their short position.

This ability to create and redeem units limits the impact of large order. It also means that liquidity ultimately rests in the underlying investments. Even if an ETF only averages 5,000 units per day, much larger trades can be made with minimal impact. Many ETF providers offer assistance with executing large trades through a hotline number.

As an underlying basket is assembled, the expected trading costs and market impact are effectively dependent on the trade volume of the underlying basket rather than the ETF itself. In this respect, ETFs are indeed quite different from traditional stocks.

Timing is (almost) everything

One of the very attractive features of ETFs is that they usually trade very close to their Net Asset Value (NAV). This is generally true, except sometimes at the open and close each day. At the open and close, ETFs are more likely to trade at a premium or discount for a variety of reasons.

For example, during the open each day, ETF prices may adjust to the difference between the previous day's closing price and their NAV. If the ETF was trading at a premium, it may move down toward its NAV; if it was trading at a discount, the price may rise closer to the NAV.

During the market close each day, traders close positions and hedge their books. These practices often result in some volatility and ETFs may see price changes and greater spreads between the bid and the ask.

The open and close are also unique because it's harder to continuously arbitrage ETFs at those times. There could be a delayed opening on the stocks held by the ETF, leaving an imperfect hedge for the market maker, thus widening the bid-ask spread for the ETF. Throughout the day, however, ETFs are continuously arbitraged and price is therefore kept very close to the NAV. If an ETF is trading at a discount, arbitragers will buy ETF units and short the underlying stocks. With this transaction, they have neutralized their exposure to the market and locked in a profit, all within a fraction of a second. Conversely, if there's excess demand for an ETF and it starts trading at a premium, arbitragers short the ETF units and buy the underlying stocks. These types of arbitrage opportunities are common throughout the day and while the profits may be a fraction of a penny per share, the profit can be quite attractive when executed multiple times a day and on thousands of shares at a time.

For the reasons outlined above, those who regularly trade ETFs are cautious when trading near the market open and market close of each trading day.

Know your limit

Market orders are a suitable choice for ETFs with tight spreads and sufficient liquidity relative to your order size. But if the tight spreads and sufficient liquidity are not there, as can be the case with some Canadian ETFs, a limit order may be a better choice.

When an ETF has a wide spread, there are several factors to consider.

  • When using a limit order, your order will never be filled at a price worse than your limit. There is a best execution obligation that must be met in the marketplace, and so a trade will never be filled at a price worse than your limit price. If the market price is better, your order will fill at the market price rather than your limit price.
  • When the spreads are wider, say $0.05 or more, there is a possibility that your order will be filled between the bid and ask. With wide spreads, investors may not be willing to trade at the market price and so may post a limit order between the bid and ask. With a narrow spread, say $0.05 or less, it will be more difficult to trade between the bid and ask. At such times, a buy limit order at the ask or a sell limit order at the bid may be the way to go if you want to increase the odds of your order being filled.

At the market opening, the bid-ask spread on ETFs may be wider than during the rest of the day. This could be because there is an imperfect hedge for market makers – perhaps an underlying stock in the ETF has a delayed opening. During the market opening and closing, a limit order may be preferable. Similarly if the ETF has a global mandate (e.g. European stocks), the best liquidity and tightest spreads are often when the European markets are open.

Learn more

While this series has touched on certain of the more commonly misunderstood aspects of trading ETFs, it's just a sampling. Fortunately, the resources on ETFs in the Canadian market are extensive. In addition to the latest media coverage of this fast growing sector, each of the ETF providers are a great source of current information.

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