Recent events such as the “Flash Crash”, the Japanese tsunami, and the bout of heightened market volatility experienced in August have brought the potential pitfalls of intraday liquidity—often touted as a key selling point of exchange-traded products (ETPs)—into plain sight. Through these periods, there have been several instances where market makers in ETP shares have headed for the hills and taken their promises to make orderly and accurate markets in these products with them. Now, more than ever, it is crucial for investors to understand the sources of ETP liquidity, how to measure it, and how to manage ETP transactions in challenging market environments.
Sources of ETP Liquidity
Exchange-trade products (ETPs) have two key sources of liquidity: the primary and secondary markets. The primary market is where ETPs are born. Within the primary market, authorised participants (APs) can create new ETP shares by delivering cash or securities to the ETP provider in exchange for new ETP shares. APs can hold these shares and ultimately redeem them for cash or securities from the provider, or they can turn around and sell them on the secondary market.
For investors looking to buy an ETP, secondary market liquidity is what matters most.
There are readily-available factors to assess when sizing up the liquidity of an ETP on secondary markets: assets under management (AUM), exchange-traded volume, the number of market makers, and bid-offer spreads.
First, there is the ETP's level of AUM. Larger ETPs--as measured by AUM--tend to be more liquid than their smaller peers.
The second factor to consider is the average trading volume for the ETP on the relevant exchange. This information can typically be found on both the product provider's and the exchange's Web sites. Volume is often stated as the number of shares of the product that traded on the exchange during a specific time period. To compare volume more directly across products, it is important to account for differences in share prices (i.e., an ETP with a price of 800p that trades 500,000 shares a day is much more liquid than an ETP with a price of 100p that trades 1,000,000 shares a day, because more money flows into and out of the first ETP). Thus, looking at volume as expressed in aggregate monetary terms will provide a more precise measure of liquidity.
Next, it is worth examining the number of market makers that there are for the ETP (some providers will include this information on a product's fact sheet, usually available on their Web sites). The larger the number of market makers, the more likely that competitive bidding amongst them will serve to drive down bid-offer spreads.
Finally, there are the bid and offer prices. These are typically located on the websites of the ETP sponsor, the exchange, or are available through brokerage quotes. With these prices in hand and the current market price, one can calculate the bid-offer spread. The bid offer spread is commonly quoted as a percentage of the relevant security's market price. For example, if the bid price for shares of an ETP is 99p, the market price is 100p, and the offer price is 101p, then the bid-offer spread is 2p or 2%.Narrower spreads are reflective of more active buyers and sellers, and hence a more liquid product. All else equal, lower bid-offer spreads equate to lower transaction costs for both buyers and sellers.
Some secondary market participants will often trade off-exchange or over the counter (OTC). OTC transactions are dominated by institutional buyers and sellers dealing in large amounts. These transactions are a very important--and underreported--source of secondary market liquidity, probably accounting for 50% or more of all trading volume. Because ETPs currently fall outside of Markets in Financial Instruments Directive (MiFID) reporting requirements, OTC transactions are not required to be reported. Therefore, official on-exchange volume statistics tend to underestimate secondary market liquidity.
For those looking to execute a large trade or place an order for a thinly-traded ETP, a call to one of the ETP's market makers may be in order. Generally, if an investor is looking to place an order that represents over 30% of a product's average daily volume, it is best to deal directly with a market maker to ensure more cost-efficient execution.
Practical Advice for Trading ETPs
The first tactic is obvious: invest in the most liquid options available. Investors can size up which of their options is the most liquid by scanning some of the measures mentioned above. Next, when considering trading shares of a less liquid ETP, or during periods of extreme volatility within the markets, investors should use limit orders. Using limit orders allows investors to take control of their execution price when dealing in less liquid products with wider bid-offer spreads. A buy limit order will ensure that shares are purchased at a pre-specified price or lower, while a sell limit ensures that shares are sold at a desired price or better.
Finally, before investing in an ETP that tracks a foreign index—it is important to first check one’s watch. The pricing of ETPs tracking foreign benchmarks is going to be most accurate during their domestic markets' regular trading hours, when all of their component securities are being feverishly bought and sold. So prior to putting a buy order in for an S&P 500 ETP first thing in the morning, think twice. It may pay to wait until the U.S. market has opened to ensure more accurate pricing.
This article was originally published September 2011.
