Product Guide ETF LIQUIDITY Comprehensive Information on ETF Trading for Australian Institutions
3 INTRODUCTION 4 UNDERSTANDING ETF LIQUIDITY 5 ETF Trading in the Secondary Market 7 ETF Creation and Redemption in the Primary Market 9 UNDERSTANDING ETF COSTS 9 The Total Cost of Ownership for ETFs 11 A Closer Look at Bid/Ask Spreads and Premiums/Discounts 13 BUYING AND SELLING ETFS 13 Ensuring Best Execution 16 Common Questions About ETF Trading 17 BEST PRACTICES WHEN TRADING ETFS 18 GLOSSARY
INTRODUCTION The exchange traded fund (ETF) industry has grown rapidly over the past two decades and now accounts for more than US$2.9 trillion in assets under management worldwide. 1 ETFs are today used by all types of investors from very large institutions to private individuals, who employ them in a wide variety of strategies that range from short-term tactical trading to long-term asset allocation. The growing popularity of ETFs reflects their ability to provide a cost-efficient way to invest in tightly specified asset classes, markets or sectors, while retaining a high degree of flexibility when it comes to implementing the entry into and exit from investment positions. These strengths are increasingly appreciated even among investors who are not yet significant users of ETFs. However, some aspects remain an area of uncertainty to some investors, which may be preventing even more widespread adoption especially in Asia Pacific.However, in practice the unique structure of ETFs means that underlying liquidity for large transactions may be far greater than these measures suggests, which may be leading investors to rule out certain products due to an incomplete picture of their true liquidity. For example, liquidity is a key feature of ETFs and individual product liquidity is often judged solely by on-exchange trading activity. Similarly, costs are often viewed in terms of expense ratios, as is the practice with traditional unlisted managed funds. But the true cost of owning an ETF incorporates a number of other factors, meaning that simply comparing expense ratios can be misleading. Even the process of executing an ETF trade can be a source of confusion to some investors who are more familiar with on-exchange or over-the-counter (OTC) trading of securities such as stocks or direct investment into collective investments such as unlisted managed funds. With ETFs, both these types of execution are potentially available to larger investors, so obtaining best execution requires an understanding of which approach is more suitable in any given situation. This guide aims to clear up these misunderstandings and provide investors with a deeper understanding of how they can turn the trading feature of ETFs to their advantage. It outlines the implications of how ETFs are constructed, provides guidance on evaluating ETF liquidity and costs, and addresses some of the most frequently asked questions about ETF trading. Finally, it concludes by providing a summary of best practices that investors should bear in mind when buying and selling ETFs. 1 ETFGI Press Release: Global, as at February 2015 State Street Global Advisors 3
Guide to ETF Liquidity UNDERSTANDING ETF LIQUIDITY Liquidity is a key feature of ETFs versus some alternative methods of gaining investment exposure. Consequently, potential investors choosing between two or more ETFs as a means to access a specific market will often place considerable weight on which product offers the highest liquidity. However, investors who are not fully familiar with how ETFs are structured and traded may use too narrow a definition of liquidity in this situation. Due to their open-end structure, ETFs offer liquidity through both a primary and a secondary market, which are defined as follows: Primary market transactions are those that result in the creation or redemption of new ETF units. These take place off exchange and directly involve the ETF manager. The liquidity in the primary market is derived from the liquidity of the underlying securities, and large transactions can be processed without causing a market impact. The value of market impact varies between funds and depends on the liquidity profile of the underlying securities, but in general, the primary market offers a great depth of liquidity to facilitate very large transactions. Secondary market transactions are those involving the purchase and sale of existing ETF units. These typically take place on exchange although they also include bilateral over-the-counter block trades and do not involve the ETF manager. The liquidity in the secondary market is measured by average daily trading volumes as recorded in the systems of the exchange where the ETF trades. Assessing the overall liquidity of an ETF requires us to consider the liquidity in both the primary and secondary together. We will begin by reviewing the factors affecting secondary market liquidity in the three main ETF trading regions of Asia, Europe and the US. We will then outline how the ETF creation and redemption process works in the primary market and see how focusing solely on measures such as average daily volume (ADV) in the secondary market can give a misleading impression of how liquid a specific ETF genuinely is. Figure 1: The ETF Eco-System and Relationship with Liquidity Retail Investors Institutional Investors Increasing levels of on-screen liquidity Primary Market Liquidity depends on the securities underlying liquidity Liquidity through brokers in secondary market trading Proprietary Traders ETF Market Makers Authorised Participants/ Participating Dealers Secondary Market Liquidity depends on quoting depth Sourcing liquidity through authorised participants for creation/redemption (either due to size or investor preference) 4
ETF Trading in the Secondary Market $494.8 BILLION Europe 2,109 ETFs $2.1 TRILLION US 1,667 ETFs $220 BILLION APAC 744 ETFs Source: SSGA, ETFGI Press Release, as at 28 February 2015. State Street Global Advisors 5
Guide to ETF Liquidity US The US is the oldest ETF market having launched the world s first ETF, the SPDR S&P 500, listed in January 1993. Total ETF assets under management in the US have grown healthily over the past two decades and stood at US$2.1 trillion as of 28 February 2015. The coverage of the 1,667 ETFs available ranges from both broad exposures like developed and emerging markets equities and fixed income to the more niche approaches such as those ETFs utilising active and advanced beta strategies. 2 The range of products available is impressive and the market benefits from strong participation by both institutional and retail investors. As a result of this maturity and diversity, the US enjoys a highly dynamic ETF industry where critical mass and scale can be built easier than in more fragmented markets. This results in generally higher trading volumes and tighter product spreads. Ignoring the true liquidity of APAC ETFs often results in flows directed to US or European ETFs that have higher trading volumes in the secondary market and consequently may seem more attractive. However, by buying overseas, many investors might be subject to pricing uncertainty, less convenient settlement and potentially adverse tax consequences. APAC The on screen liquidity of APAC ETFs is typically lower on average than is that of ETFs in US or European markets. There is a tendency to transact ETFs in over-the-counter markets. This means that it is particularly important for investors in APAC to look to the true liquidity of the funds and not focus solely on average daily volume (ADV). As noted above, ADV is not the only indicator of an ETF s overall liquidity but represents only the number of units traded in the secondary market. Investors also should consider the liquidity of the primary market. Europe Europe has seen significant growth in ETF use since the first product listed in the region in 2000. AUM stands at US$494 billion as of 28 February 2015, keeping pace with growth in the more mature US ETF market. 3 But despite this impressive asset growth, investors expecting to see strong trading volumes on their domestic exchanges are often disappointed with typically low ADV figures and at times unattractive bid/ask spreads. However, two factors unique to the European market can make ADV a misrepresentation of underlying ETF liquidity. These are market fragmentation through multiple ETF exchange listings (and sometimes multiple currency listings at each exchange) and a lack of trade reporting requirements. 2 ETFGI Press Release: United States, as at February 2015 3 ETFGI Press Release: Europe, as at February 2015. 6
ETF Creation and Redemption in the Primary Market While many investors may already be familiar with how ETFs trade in the secondary market, details of the primary market the process by which ETF units are created and redeemed are not so widely understood. However, as noted above, primary market activity plays an equally crucial part in determining an ETF s true level of liquidity. In this section, we will outline how the ETF creation and redemption process works, and the roles played by the main participants in this market. How ETF Units are Created and Redeemed Understanding the creation/redemption process is key to understanding the true extent of an ETF s overall liquidity. Creation and redemption take place in the primary market and are direct transactions between the ETF managers and Authorised Participants (APs). These transactions regulate supply of ETF units in the secondary market. Creation is the process by which additional units are introduced to the secondary market. APs create fund units in large increments known as creation units by assembling the underlying securities of the fund in their appropriate weights to reach creation unit size (e.g.,100,000 units) and then delivering those securities to the fund. In return, the AP receives units, which they can then sell in the secondary market, increasing the supply of units that can be traded by other investors. APs also have the ability to redeem units through the same process in reverse. The AP collects large increments of units known as redemption units in the secondary market and then delivers them to the fund in exchange for the underlying securities in their appropriate weighting equalling the redemption unit (e.g.,100,000 units). This reduces the supply of units available in the secondary market. From the perspective of the ETF and its investors, this process serves to keep the market price of the units and the net asset value in line. A further advantage is that the ETF s portfolio manager typically does not have to buy or sell securities except for rebalancing purposes, reducing dealing costs and in some jurisdictions tax liabilities. The AP participates because it can profit from creating or redeeming units in a number of ways, including arbitrage, inventory management, customer facilitation and equity finance/stock loan. Figure 2: ETF Creation/Redemption Process The Primary Market PRIMARY MARKET SECONDARY MARKET Underlying Securities Buyers SPDR ETF SPONSOR AUTHORISED PARTICIPANTS (AP) ETF Units STOCK EXCHANGE Source: State Street Global Advisors, as of 02 April 2015. ETF Units Sellers State Street Global Advisors 7
Guide to ETF Liquidity Participants in the Creation/ Redemption Process Many of the terms below are used interchangeably to refer to the different firms that trade ETFs. Although many of the terms are similar, there are key differences between them. What is the Difference Between an AP and a Market Maker? Authorised Participants have the ability to create or redeem ETF units for funds with which they have properly executed legal documentation. If a client were to contact an AP and inquire about trading an ETF, the AP would be able to make a market in that specific ETF for the client. There is a distinct and important difference between making a market when asked (as in the above example) and being an exchange market maker with publicly available prices posted. Usually (although not always) market makers are also APs. Throughout most exchanges around the world, an ETF must have at least one market maker who is required by the exchange to provide prices at all times throughout the trading day. Typically called an official market maker, designated sponsor or lead market maker (the nomenclature varies by exchange), these particular market makers are different from market makers who make prices whenever and at whatever spread/size they deem appropriate. The spread and depth of the official market maker s quotes are subject to the exchange-imposed limits and often ETF manager-defined maximum spread/size requirements as well. Authorised Participant (AP) or Participating Dealer (PD) APs have fully executed legal documentation which gives them the ability to create new ETF units or redeem existing ETF units. Market Maker An all-encompassing term referring to a firm that is willing to provide a price to a buyer or a seller of an ETF. A market maker may or may not be an authorised participant. Market makers provide prices either on an exchange or over-the-counter. On Exchange Market Maker A firm that provides buy and sell prices for ETFs on a stock exchange. This includes market makers who provide prices in an official capacity (with signed exchange documentation and certain spread, depth, presence requirements), as well as market makers who provide prices unofficially without any exchange-imposed requirements. Designated Sponsor, also known as Lead Market Maker (ASX), Designated Market Maker and (SGX) Securities Market Maker (HKEx) A firm responsible for providing prices for an ETF on an exchange. There may be multiple Designated Sponsors per fund. All are subject to predetermined, exchange-imposed spread/depth requirements. Should Large and Frequent Creation and Redemptions in ETFs Cause Concern for Investors? Institutions were the first to adopt ETFs in the early 1990s, using the funds as cash equalisation vehicles. While much has changed in the industry over the past two decades, institutions have consistently remained among the largest ETF investors. Given their scale, institutions tend to trade ETFs in larger volumes than the average buy or sell order. As a result of the unique creation and redemption process, all trading-related costs are placed with the party that is creating or redeeming in the fund; the ETF s portfolio manager typically does not need to buy or sell securities except for rebalancing purposes. Unlike in a traditional unlisted managed fund, a portfolio manager does not incur cash drag by allocating a portion of the portfolio to cash and risk, potentially underperforming the index they are benchmarked against, as he does not need to meet the transaction costs of executing buys and sells. Thus, despite frequent inflows and outflows into an ETF, there should not be a significant impact on performance because securities do not need to be bought or sold on the margin. 8
UNDERSTANDING ETF COSTS Costs rank alongside liquidity as the second major factor when selecting ETFs for most investors. However, in the same way that many users base their evaluation of liquidity on an incomplete measure of overall ETF liquidity (in the form of ADV), they also simplistically reduce costs to a single number the expense ratio. In the first part of this section, we will examine the main factors that investors should take into account when calculating the total cost of ownership for an ETF. In the second part, we will show how some of these can vary in response to changing market conditions. The Total Cost of Ownership for ETFs We will begin by defining the total cost of ownership for an ETF. This is made up of a number of explicit and implicit costs, including expense ratio, commissions and bid/ask spread, as well as other factors such as tracking error. We will review each of these in turn. Expense Ratio The expense ratio represents the portion of your investment that the fund charges on an annual basis for management fees. These costs incurred range from investment management and administration expenses to custodial and index licensing fees. Consider that the average Australian shares large cap blended ETF has an expense ratio of just 31 basis points (bps) compared to 137 bps for the managed fund in the same category. The disparity is uniform across the Australian shares and bonds product set and is just as pronounced for international share funds. In terms of expense ratio, the average blended international shares ETF has an expense ratio of 33bps whereas the average international shares managed fund has an expense ratio of 149bps. Extensive work has been done that demonstrates the impact of a fund s expenses and fees on an investor s net return. In this arena, ETFs have a compelling and decisive advantage. However, ETFs are structured and trade differently than unlisted managed funds, so investors need to look beyond the expense ratio to calculate costs. Figure 3: ETF Cost of Ownership Investors also may wish to compare expense ratios between similar ETFs. All else being equal, lower expense ratios are positive for investors. However, they are not the only variable ETF investors should consider when evaluating total costs. Because ETF expense ratios are already low across many categories, savings generated by a reduction in fees can be offset by other variables such as wide bid/ask spreads and premiums/discounts. Commissions + + + Expense Ratio Commission Spread (Tracking Error) Total Cost of Ownership Source: State Street Global Advisors, as of 02 April 2015. A commission is the service charge assessed by a broker or agency in return for providing investment advice and/or handling the purchase or sale of a security. Most major, full-service brokerages derive most of their profits from charging commissions on client transactions. Commissions vary widely from firm to firm. Frequent trading of securities, including ETFs, could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. Commissions can vary according to: the type of client, the type of broker (agency vs. online broker), investment size, trading volume, frequency of trading, order type and other factors. State Street Global Advisors 9
Guide to ETF Liquidity The Bid/Ask Spread The bid is the price at which a buyer is willing to buy ETF units. The ask is the price at which a seller is willing to sell ETF units. The difference between the bid and the ask is the bid/ask spread, which indicates the overall cost of transacting in any security (plus any applicable brokerage commission costs). Theoretically, the difference between the bid/ask spread midpoint and ask plus commissions is the transaction cost of buying ETF units. The difference between the bid/ask spread midpoint and bid plus commissions is the transaction cost of selling ETF units. Investors can see the depth of a particular ETF by examining the full order book. High volume does not necessarily mean a market is deep and a deep market does not necessarily mean a market is highly traded. Tracking Error Understanding tracking error is also important in understanding an ETF s overall cost. Tracking error is the annualised standard deviation of the difference in the fund s performance relative to their benchmark. Depending on an investor s time horizon, tracking error can be measured daily, monthly, quarterly or annually. For example, an investor actively trading ETFs is more concerned with how an ETF tracks on a daily basis, whereas a long-term investor may only monitor a fund s tracking on a yearly basis. In either case, funds with tighter tracking should have a competitive advantage. With an ETF that seeks to track the performance of an index, ideally, the fund should tightly track the underlying index. Profound differences in performance between a fund and its corresponding index may be a red flag for poor fund management or excessive trading costs. However, not all ETFs are created equal. ETFs can employ a full replication, optimisation-based, synthetic replication, or active management approach to govern portfolio construction and trading decisions. These different approaches dictate how closely a fund tracks its index, and how well a fund suits a given portfolio. When evaluating tracking error, it is also important to look at a fund s underlying index. Index construction and methodology and the potential for tracking differences and taxes can also offset any benefits of a lower expense ratio. Evaluating the Total Cost of Ownership The hypothetical example in Figure 4 illustrates how these inputs can affect the overall cost of two different ETFs. An investor may want to choose ABC ETF due to its lower expense ratio alone, but when the commission and spread are taken into account, XYZ ETF may be the better choice from a total cost perspective. Figure 4: Hypothetical ETF Ownership Scenario Costs ABC ETF (bps) XYZ ETF (bps) Expense Ratio 20 30 Commission 10 10 Spread 15 2 Total Cost of Ownership 45 42 The information contained above is for illustrative purposes only. Source: State Street Global Advisors. 10
A Closer Look at Bid/Ask Spreads and Premiums/Discounts Although the price of units in an ETF should be closely related to the value of the ETF s underlying assets, the relationship can fluctuate to some extent, both temporarily and on a more persistent basis. This can manifest itself in two main ways: Changes in the width of the bid/ask spread and changes in the premium or discount between the ETF price and the value of its assets. In the following section, we will discuss some of the factors that determine the size of both bid/ask spreads and premiums/ discounts, together with their implications for ETF investors. What Does the Bid/Ask Spread Represent? To better understand what an investor is paying for in a bid/ask spread, it is helpful to have an understanding of how the trading firms that specialise in buying and selling ETF units operate. Like most businesses, cost to the end consumer is highly correlated to input costs, plus a profit. In this respect, ETF trading is no different from any other business. As such, ETF traders generally need to account for four different categories of cost when facilitating ETF trades. If any of these four cost categories above rise, this is reflected in an ETF s spread, meaning investors transacting in an ETF pay higher fees to participate. Much like a farmer who raises prices after an increase in the price of fertiliser, water or equipment, an ETF trader will widen spreads if any of his/her costs or risks rise. 01 Risk At times, risk can be the highest cost component of spreads, especially during periods of elevated market volatility. Most traders who facilitate ETF orders aim to remain market neutral since they generate their revenues through order execution, not investment appreciation. What most investors would call investment exposure ETF traders call risk. In order to manage this risk, traders will hedge investment exposure with the use of underlying securities, options, futures contracts, or even other ETFs. Depending on the liquidity of the underlying instruments used to initiate a hedge, it can be costly to maintain market neutrality when trading ETFs. This hedging cost will be included in an ETF s spread and passed along to investors trading in the secondary market. Traders are often unable to be completely market neutral and so will pass on any remaining market exposure risk through wider spreads. Additionally, market makers rely heavily on the information provided in the daily PCFs provided by PCF calculation agents. In addition, in times of volatility market makers may widen spreads in light of uncertainty regarding a fund s components and thus its true price. 02 Cost of Buying/ Selling Basket Securities One major variable cost that ETF traders often encounter is that of gathering the underlying securities in an ETF basket. For less liquid, esoteric asset classes, such as high yield or municipal markets, this cost is greater. Thus, spreads tend to be wider for ETFs with more thinly traded underlying markets. In the case where an AP chooses to exchange cash for ETF units, it is the sponsor s responsibility to charge the AP any and all execution costs associated with the creation or redemption of ETFs to protect the fund from assuming execution costs. This fee typically includes all relevant taxes, commissions and any other costs assumed in executing the underlying basket. 03 Business Cost As the business of ETF trading continues to be closely tied to rapidly moving markets and the continuous need for faster technology, trading firms must constantly reinvest to stay competitive. Moreover, the requirement of multiple exchange memberships and associated costs can quickly add up with these costs often finding their way into the spread of an ETF. Moreover, the requirement of multiple exchange memberships and associated costs can quickly add up with these costs often finding their way into the spread of an ETF. 04 Creation/Redemption Fee Otherwise known as third party administrator (TPA) charges, or custody charges, this is a fee passed on by the ETF administrator that represents the cost of settling the underlying stock of an ETF on a line-by-line basis. These costs tend to be higher for more esoteric, thinly traded securities in emerging markets. Since this charge is per line of stock regardless of creation or redemption size, costs diminish (in percentage terms) as order sizes increase. State Street Global Advisors 11
Guide to ETF Liquidity Figure 5: Components of the Bid/Ask Spread Transaction Costs F/X Costs Creation Fees Inventory Costs Commissions to execute locally Local taxes Spreads of Underlying Slippage of Underlying Commissions to execute F/X F/X Taxes F/X Spreads F/X Slippage The fee charged to create a unit For an ETF with low volume, particularly those with large creation sizes, the capital charges to hold a unit Market Offer Market Bid Market Offer Source: State Street Global Advisors, as of 02 April 2015. How Does the Spread of an ETF Change Over Time? Although there are certainly a number of factors that contribute to the spread of an ETF, studies have shown there is one main factor that tends to compress spreads: secondary market trading volume of an ETF. Over time, as secondary market trading volume increases, there is a high correlation with tightening spreads (as demonstrated by Figure 6). As volume in an ETF rises, competition lowers spreads and allows investors to transact in a more cost efficient manner in the secondary market. Often times, significant secondary market trading volume can trump the other three costs (i.e., creation/ redemption fees; spread of the underlying securities in an ETF basket; and risk). This means that at a certain point an ETF may hit a tipping point where it becomes more liquid than the underlying securities that compose it. Do Spreads Vary for Different Asset Classes? All of the above-mentioned cost components that make up the spread of an ETF vary by asset class and type of exposure. Risk varies by asset class, and the ability to produce a neutral hedge depends on the availability of hedging tools. Associated costs also vary by market, e.g., in some markets transaction taxes are charged, business costs are generally higher in emerging markets, and larger baskets incur larger creation/ redemption costs. In general, the broader the index (in terms of the number of constituents) and the more exotic the underlying securities are, the higher the spread, trading and transaction costs will be. Figure 6: Example of ABC Fund Trading Volume ($ million) 5 4 Spread (BPS) 50 40 3 30 2 20 1 10 0 Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug 0 2012 2012 2012 2012 2012 2012 2012 2012 2012 2012 2012 2012 Volumes (Shares Traded) Average Spread (BPS) The information contained above is for illustrative purposes only. 12
BUYING AND SELLING ETFS In the first two sections of this guide, we have outlined the structure and trading arrangements of an ETF which affect liquidity and costs of ownership. For this final section, we will draw on this to discuss how investors can buy and sell ETFs in the most cost-effective way, as well as addressing a few common questions and misconceptions about the ETF trading and settlement process. Ensuring Best Execution There are primarily two layers of liquidity regarding an ETF. The first is the available liquidity in the secondary market, while the second is the liquidity of its underlying securities. To access all available liquidity of an ETF, investors must understand and evaluate the various ways they can buy and sell them. On Exchanges/Secondary Markets On stock exchanges, participants post bids and offers at price levels at which they are willing to buy or sell a particular number of units of a given ETF. There are several different order types that can be used to introduce ETF orders in a secondary market. The most appropriate order type for ETF orders may be the marketable limit order. A marketable limit order is a limit order to buy or sell at or below/above the consolidated best offer/bid for a security. To understand why investors may use limit orders when buying or selling an ETF, a look at the quote for a hypothetical ETF (XYZ) is useful. (If your systems do not provide access to a full order book, we recommend speaking with your dealing desk to get a full picture of the depth of quote for a given ETF.) Consider the impact of a market order versus a limit order for an investor who wants to purchase 20,000 units of XYZ. In this example, as Figure 7 illustrated, the average execution price for a 20,000-share market order would be $36.35 or $0.10 from the best offer available. This is because only 1,000 units are offered at the best offer price of $36.25. The remainder of the trade is then executed at higher price levels until it has been fully executed. As a result, a market order for 20,000 units would sweep through the available liquidity, in this case, at all four levels shown. To maintain greater control over the execution price, the investor could place a marketable limit order at the national best offer of $36.25, which would immediately execute 1,000 units at that price. The market maker then would have the chance to post additional units at this price level. Figure 7: Hypothetical Order Book for XYZ ETF XYZ Bid XYZ Ask Units Price ($) Units Price ($) 1,000 36.11 1,000 36.25 1,000 36.10 3,000 36.30 10,000 35.96 12,000 36.35 3,000 35.95 4,000 36.39 The information contained above is for illustrative purposes only. State Street Global Advisors 13
Guide to ETF Liquidity Market Order Limit Order Pros Order is usually filled quickly Control over execution price Cons No control over execution price Chance order will not be filled entirely sense to execute directly via an exchange. In these circumstances, it may make sense to execute trades via a liquidity provider. Liquidity providers for ETFs are most often APs as they can seamlessly create or redeem shares of an ETF. Liquidity providers who are not APs usually have relationships with firms that are APs, and can create or redeem on their behalf. Below are two common ways to execute large ETF trades with a liquidity provider. This example highlights why market orders should generally be avoided with ETFs, especially with those that are more thinly traded. Although market orders provide faster execution of an entire order, the lack of control over the price can lead to unintended trading slippage. With limit orders, the trade-off is less immediate execution, but greater control over price. One risk with limit orders is that the entire trade may not be filled. To increase the probability that an entire trade will be filled, investors can enter more aggressive limit orders for instance, at a price that is higher than the national best offer available when buying. One way that investors determine the prices at which to enter their limit orders is based on the inav (indicative Net Asset Value). Since the inav is calculated based on the price of underlying securities, it is an accurate measure for domestic equities; however, it is less accurate for markets that are closed during domestic trading hours or markets that are not as transparent(such as fixed income ones). It is also worth remembering that the inav does not take into account any costs associated with buying or selling an ETF s underlying basket, or other costs associated with trading an ETF. Consider speaking with your dealing desk or ETF provider regarding how to most efficiently enter an ETF order if you are unsure of what these costs may be. Over-the-Counter (OTC) Trading or Large Trades The fact that investors have the ability to trade ETFs overthe-counter introduces a new and unique venue by which to implement trades. Despite the transparency of a secondary market, investors may face certain situations where the size, intricacy, or sensitivity of a trade might not make the most Risk Trade One way investors can interact with a liquidity provider is through a risk trade. With a risk trade, a liquidity provider will quote a market for a given ETF at a given size. For example, if a client is looking to buy 125,000 units of ETF XYZ, the liquidity provider will calculate its risk and offer the client a price at which they are willing to sell the 125,000 units to the client. If the client finds the price agreeable, then the trade is executed over-the-counter. The reason this is referred to as a risk trade is because once the trade is executed, the liquidity provider assumes the market risk of the position and will work to hedge his position to limit risk. If the trade is large enough, the liquidity provider may create or redeem units to complete the trade. This does not concern the client, as the trade was executed at a pre-determined price, regardless of how the units are obtained. For instance, a liquidity provider may have existing inventory in a fund. It could go to an exchange to gather units, or contact another AP that has existing inventory it is willing to pass along at a mutually agreeable price. In Asia, this broker-to-broker network is quite active, and is something ETF providers can help to facilitate where appropriate. What is the inav? The inav is the intraday net asset value of a basket of securities that underlies an ETF, and provides a yardstick of the current bid/ask price. The inav is disseminated every 15 seconds and is calculated by a third party data provider who has been selected by the fund sponsor or the exchange. The inav may also be known as the indicative optimised portfolio value (IOPV) or the reference underlying portfolio value (RUPV). 14
NAV + Trade (Creation and Redemption) Another way investors can interact with a liquidity provider is through a NAV + transaction cost, also known as a creation or redemption. The majority of these transactions take place between clients and liquidity providers who are set up as APs in the specific funds they want to trade. In this scenario, an investor arranges to create or redeem units with an AP. The end price the client pays or receives for the units is based on the closing NAV as well as any implicit costs which the AP incurs in the process of creating or redeeming the units. As previously noted, these costs include many of the trading costs outlined in Section 2. Given the nature of a NAV + trade, market risk is accepted by a client until an order s NAV is determined. Since any market risk is taken on by the client, this tends to be the more cost-efficient way of transacting in a fund. It is important to note, however, that any market risk assumed by a client in a NAV + trade, although difficult to quantify, could translate into unintended market movement costs. Figure 8: A Summary of How Investors Can Trade ETFs ETF trades take place in the secondary market (on exchanges or OTC). For large trades, investors can access deeper liquidity through liquidity providers (LPs) Secondary Market Source: State Street Global Advisors. Primary Market On Exchange OTC Creation/Redemption Buyers and sellers are matched through an exchange On screen orders typically traded directly in the market or through algorithms ETF Liquidity Pool Liquidity providers are able to access deeper pools of liquidity OTC LPs can transact in the underlying securities and offsetting hedges like futures, options, highly correlated ETFs, etc Authorised Participants can also create or redeem shares directly with the ETF manager Client receives NAV plus any associated trading costs plus fixed creation cost with ETF manager For example, certain ETFs are unable to confirm NAV until one day after an order has been accepted. This tends to happen with ETFs tracking global benchmarks that may have securities in the underlying basket that are closed for trading at the time an order is received. As such, the market can potentially move significantly (either positively or negatively) between the time when a client places an order in the ETF of choice and when the NAV is confirmed the next day. For clients with a shorter term, more tactical view on their ETF choices, this market risk tends to be less than ideal given the nature of their investment goals. Each of the above scenarios allows investors to access deeper pools of liquidity than are offered by an ETF itself in a secondary market. The main difference between the two examples is that an investor transfers market risk to an AP and receives an immediate price and execution in a risk trade while maintaining market risk until the NAV is confirmed for a NAV + trade. The reason for using one method over the other is based on an investor s goals. State Street Global Advisors 15
Guide to ETF Liquidity Common Questions About ETF Trading The ability to buy and sell an ETF continuously through the trading day carries obvious advantages for investors, but may also imply potential disadvantages or complications. However, these are generally eliminated or mitigated by other aspects of the ETFs structure. This section will provide a brief clarification of a few common questions and misconceptions that result from an incomplete understanding of the way in which ETFs trade. How Does Price Discovery Work When Markets are Closed? Where ETFs invest solely in securities that trade during the same market hours as the ETF itself, the process of calculating the ETF s fair value at any point during the trading day is relatively straightforward. However, many ETFs invest in securities listed on foreign exchanges that will not be open during trading hours. In general, market makers construct models to approximate the fair value of ETFs that contain underlying securities, but whose exchanges may be closed at the time of trading. Usually this involves the tracking of movements in instruments that are trading in real-time, such as S&P 500 index futures, other Asian markets and various currencies (as the foreign exchange market is continuously traded). It is in the interest of market makers to be as efficient in this regard as possible, as they usually use these models to hedge away their risk until the true underlying securities can be traded once the market opens. For example, a SPDR ETF covering World ex-australia is comprised of underlying securities that trade on exchanges in Asia, Europe and US, while the product trading on the Australian stock market during Australian market hours, when the Asian market is open later in the day as compared with European and American markets which are never open during local market hours. In these cases, the above-described hedging techniques help to reduce trading spreads. However, when the underlying markets are closed, bid/ask spreads may be wider as there is still a level of uncertainty when the pricing is based on model approximation. Do ETFs Trade Effectively in Volatile Environments? In the wake of September 11, 2001 and the global financial crisis of late 2008, ETF trading volumes increased sharply as investors looked to ETFs because of their key attributes of transparency and liquidity. ETFs also can function as price discovery tools, providing insights into a market s view on correct pricing even during periods when the underlying liquidity for an asset class is diminished. 16
BEST PRACTICES WHEN TRADING ETFS The core principles underlying ETFs are relatively straightforward, as are their advantages for implementing many investment strategies. However, we have seen throughout this guide, there are a number of considerations that investors should bear in mind when employing ETFs to make use of the unique features of these products as effectively as possible. In particular, following the guidelines below will help to ensure successful, cost-effective execution of ETF trades. Always refer to the official NAV for valuation and performance analysis. The NAV can usually be found on the website of the ETF provider or obtained from financial data providers such as Bloomberg. Understand the distinction between the closing price and NAV for valuation purposes: The closing price is the last price of the trading day, influenced by supply and demand. The NAV is calculated by the standard methodology in the prospectus and is calculated when the underlying security price is closed. Hence ETF closing price could diverge from the official NAV and is therefore not the official valuation of the ETF. Be aware of the limitations of inav. Whenever possible you may use the inav as a rough estimate for the real-time value of an ETF you are purchasing. However, it is important to note that this is only a rough estimate as inavs do not include any transaction cost embedded in them. Moreover, inav become less reliable in more opaque, thinly traded (and sometimes closed) markets. Always be conscious that an ETF s liquidity is not limited to on-screen/on exchange representation: Larger size order can be facilitated by market makers/authorised Participants to help ensure best available execution. Take into account that not all market makers can price all ETFs equally. Each has its own specialisation and expertise. Always contact more than one market maker for an OTC transaction to find the best price. When buying on an exchange, note limit orders provide better price control and should normally be used in preference to market orders. When buying an ETF where part or all of the underlying security s market is closed, it is best to time the execution when a maximum of the underlying securities trade. All else being equal, bid/ask spreads should be smaller at this point. Open, close and auction periods are often governed by specific rules. It is prudent to familiarise yourself with these rules. Placing a trade during these periods should generally be avoided unless the investor anticipating the trade is comfortable with those rules. State Street Global Advisors 17
Guide to ETF Liquidity GLOSSARY Arbitrage A trade that attempts to profit from differences in the price of identical or similar financial instruments, on different markets or in different forms, usually by buying one asset and selling the other. Arbitrage exists as a result of market inefficiencies and provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time. Authorised Participant (AP) An entity chosen by an ETF s sponsor to undertake the responsibility of obtaining the underlying assets needed to create an ETF. Authorised participants are typically large institutional organisations, such as market makers. Bid/Ask Spread The difference between the highest price that a potential buyer is willing to pay for an asset (the bid) and the lowest price that a potential seller is willing to accept (the ask). One possible measure of the liquidity of a market. A wider spread means higher transaction costs. Central Securities Depository (CSD) An entity that holds securities such as shares in custody, enabling ownership of the securities to be transferred by updating the CSD s records instead of exchanging physical certificates. The existence of CSDs speeds up the clearing and settlement of trades. Cost of Ownership (Total Cost of Ownership) A measure of the costs incurred when investing in an ETF, unlisted managed fund or other investment. In addition to costs included in the expense ratio (such as management fees and custodian fees), it may include other components such as trading costs. Creation/Redemption The main difference between ETFs and other investment vehicles like unit trusts or stocks is the process through which fund units are created and redeemed. This is called the creation/redemption process, also known as the application/ redemption process, and takes place in the primary market between the fund and authorised participants. Authorised participants are Australian Securities Exchange (ASX) registered stockbrokers. Authorised participants create fund units in large increments known as creation units by assembling the underlying securities of the fund in their appropriate weightings to reach creation unit size (typically 100,000 fund units) and then delivering those securities to the fund in-kind. In return, the authorised participants receives fund units which are then introduced to the secondary market where they are traded between buyers and sellers through the exchange. As a result of the creation/redemption process, the ETF s portfolio manager typically does not have to buy or sell securities except for rebalancing purposes thus assisting to keep transaction costs low in comparison to traditional unit trusts. Authorised participants also have the ability to redeem fund units through the same process in reverse. Large increments of fund units known as redemption units are collected in the secondary market and then returned to the issuer for cancellation in exchange for the underlying securities in the appropriate weighting equaling that redemption unit (again, typically 100,000 fund units) which leads to a reduction in the outstanding units. Creation Units/Redemption Units Creation units are sets of units or securities that makes up one unit of a fund held by a trust that underlies an ETF. One creation unit is the denomination of underlying assets that can be redeemed for a certain number of ETF units. If an investor wants to sell a large block of units of an ETF, even if there seems to be limited liquidity in the secondary market, Authorised Participants can readily redeem a block of ETF units by gathering enough shares of the ETF to form a creation unit and then exchange the creation unit for the underlying securities. Exchange A marketplace where securities, commodities, derivatives and other financial instruments are traded. Its main function is to ensure fair and orderly trading, as well as efficient dissemination of price information, for any securities trading on that exchange. Exchanges provide a platform to sell securities to the investing public, and may be physical or electronic. Exchange Traded Fund (ETF) An investment product that tracks an index, commodity or basket of assets in a similar manner to an index managed fund, but trades like a stock on an exchange. 18
Expense Ratio The annual operating expenses of a unlisted managed fund or ETF, expressed as a percentage of the fund s assets. Hedging Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. Index A statistical measure of the value of a securities market or a section of that market. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Equity and fixed income market indices are used as the benchmark for index managed funds and ETFs, whose portfolios will mirror the components of the index. Liquidity The degree to which an asset or security can be bought or sold in the market without affecting that asset s price. Assets that can be easily bought or sold are known as liquid assets. Market Maker (MM) A broker-dealer firm that facilitates trading in a security by undertaking to both buy and sell that security at all times during trading hours. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of units. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order.net Asset Value (NAV)/Indicative Net Asset Value (inav) The value of a fund s assets less the value of its liabilities. NAVs for unlisted managed funds and ETFs are generally quoted in terms of net asset value per unit, which is calculated by dividing the total value of all the securities in its portfolio, less any liabilities, by the number of fund shares outstanding. An indicative net asset value (inav) is a measure of the intraday NAV of an investment, such as an ETF, which gives an updated measure of the value of the investment based on its assets less its liabilities. An investment s NAV is usually calculated at the end of the trading day, but the inav measure gives a more real-time view of this value. Over the Counter (OTC) A security traded in some context other than on a formal exchange (such as the New York Stock Exchange or the Australian Securities Exchange). The phrase over-thecounter commonly abbreviated to OTC can be used to refer to stocks that trade via a dealer network as opposed to on a centralised exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network. Physical ETF An ETF that tracks the performance of an index by directly investing in the securities that make up the index. Premium/Discount The extent to which the price of an asset is greater than (a premium) or less than (a discount) than its underlying value. ETFs rely on Authorised Participants to keep premiums or discounts under control by regulating the amount of ETF units available in the secondary market. Price Discovery A method of determining the price for a specific commodity, security or other financial instrument through basic supply and demand factors related to the market. Primary Market The part of the capital market in which new securities are issued by companies, governments or other groups. Primary markets are facilitated by underwriting groups, which consist of investment banks that set an initial price range for a given security and then oversee its sale directly to investors. In some countries, primary markets are also known as new issue markets (NIM). Secondary Market The part of the capital market where investors purchase securities or assets from other investors, rather than directly from issuing companies. The national exchanges such as the Australian Securities Exchange are secondary markets. In any secondary market trade, cash proceeds go to an investor rather than directly to an underlying company/entity directly. Synthetic ETF An ETF that tracks the performance of an index by means of a swap or other derivative contract, instead of directly investing in the securities that make up the index. Tracking Error The divergence between the price behaviour of a position or portfolio and the price behaviour of its benchmark. State Street Global Advisors 19
Guide to ETF Liquidity ssga.com spdrs.com.au For institutional and professional investors only. Not for public use. State Street Global Advisors Australia Services Limited Level 17, 420 George Street, Sydney, NSW 2000. 1300 665 385. Issued by State Street Global Advisors, Australia Services Limited (AFSL Number 274900)(ABN 16 108 671 441) ( SSGA, ASL ), the holder of Australian Financial Services Licence ( AFSL ) number 274900. Registered office: Level 17, 420 George Street, Sydney, NSW 2000, Australia. T: +612 9240 7600. F: +612 9240 7611. Investors should read and consider the Product Disclosure Statement (PDS) for the relevant SPDR ETF carefully before making an investment decision. A copy of the PDS is available at www.spdrs.com.au. The material is general information only and does not take into account your individual objectives, financial situation or needs. It should not be considered a solicitation to buy or sell a security. ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETF s net asset value. ETFs typically invest by sampling an index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Diversification does not ensure a profit or guarantee against loss. Sector ETFs products are also subject to sector risk and non-diversification risk, which generally results in greater price fluctuations than the overall market. Brokerage commissions and ETF expenses will reduce returns and transaction costs will also be incurred when buying or selling units of an ETF on ASX markets. ETF units may only be redeemed directly by persons called Authorised Participants. SSGA ASL is the issuer of units in the SPDR funds and the Responsible Entity for the managed investment scheme Australian SPDR funds quoted on the ASX or AQUA Product Issuer for those Australian SPDR funds quoted on the AQUA market of the ASX. State Street Bank and Trust Company (ABN 70 062 819 630) (AFSL number 239679) is the trustee of, and the issuer of interests in, the SPDR S&P 500 ETF Trust, an ETF registered with the United States Securities and Exchange Commission under the Investment Company Act of 1940 and principally listed and traded on NYSE Arca, Inc. under the symbol SPY. SSGA ASL is the AQUA Product Issuer for the CHESS Depositary Interests (or CDIs ) which have been created over units in SPY and are quoted on the AQUA market of the ASX. The rights of CDI investors are different to those of investors in an Australian registered managed investment scheme and investors should read the applicable PDS before investing to understand the additional risk factors associated with investing in CDIs. An investment in SPDR funds or SPY CDIs do not represent a deposit with or liability of any company in the State Street group of companies including State Street Bank and Trust Company and are subject to investment risk including possible delays in repayment and loss of income and principal invested. No company in the State Street group of companies guarantees the performance of SPDR funds or SPY CDIs, the repayment of capital or any particular rate of return. SPDR and Standard & Poor s S&P Indices are trademarks of Standard & Poor s Financial Services LLC and have been licensed for use by State Street Corporation. The Dow Jones Global Select Real Estate Securities Index is a product of S&P Dow Jones Indices LLC or its affiliates and has been licensed for use by SSGA. MSCI Indices, the property of MSCI, Inc. ( MSCI ), and ASX, a registered trademark of ASX Operations Pty Limited, have been licensed for use by SSGA. SPDR products are not sponsored, endorsed, sold or promoted by any of these entities and none of these entities bear any liability with respect to the ETFs or make any representation, warranty or condition regarding the advisability of buying, selling or holding units in SPDR products. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA s express written consent. State Street Global Advisors 2015 State Street Corporation. All Rights Reserved. ID3772-AUSMKT-1710 0415 Exp. Date: 30/03/2016