Tools of the Trade

Oct 4, 2018 @ 12:01 am

Given the flow of investor money into exchange traded funds, or ETFs, it's clear they've become very popular. ETFs are portfolios of holdings in which their shares trade throughout the day, like stocks. But there are some differences to keep in mind.

The Connection Between Volume and Liquidity

In the world of stocks, trading volume has always been a strong indicator of liquidity, or the degree to which stocks can be bought or sold in the market without affecting their price. However, when looking at ETFs, volume is only a reflection of what has traded—not what could have traded. ETF liquidity is easy to understand once you dive into the layers of liquidity that are present to execute a trade.

There are three levels of ETF liquidity to consider: secondary markets, market depth and primary markets.

Level One: Secondary Markets

The simplest way for an ETF to trade is for a buyer and seller to be matched on the secondary market. For this to happen, a market maker publishes quotes that represent the price number of ETF shares they are willing to buy and sell. The best of the quotes is known as the National Best Bid and Offer (NBBO) quotation. The difference in the bid and offer (also known as ask), is the spread. The spread is the payment the market maker receives for matching the buyer and seller of the ETF.

Level Two: Market Depth

The size and prices that are displayed through the NBBO are not the only quotes with which an investor can transact. For most ETFs, market makers will publish quotes beyond the NBBO, helping to provide market depth. Market makers do this so that larger size trades can be executed while covering the costs of providing the liquidity. There are a few ways to access this liquidity; including using a limit order to direct your broker to buy or sell ETF shares at a price beyond the NBBO, breaking up your trade into smaller trades, or contacting your broker/dealer's ETF block desk, which handles large purchases and sales of ETF shares.

Level Three: Primary Markets

The heart of ETF liquidity is the primary market. This is where the “creation and redemption mechanism” comes into play which is a key differentiator between ETFs and mutual funds. The volume of the underlying securities is a source of liquidity for the ETF.

When demand for the ETF shares exceeds supply, a creation ensures there is sufficient inventory to fill an investor's order. In ETF share creation, a firm authorized to purchase securities to create more ETF shares—known as an authorized participant (AP)—assembles a portfolio (or “basket”) containing the ETF's current holdings. The authorized participant turns over the basket to the ETF custodian, who is responsible for holding all the securities in an ETF. In return, the custodian delivers ETF shares that can then be bought and sold in secondary markets. This is generally done in blocks of 50,000 or 100,000 ETF shares.

ETF share redemption reverses this process when excess supply of ETF shares needs to be removed from the marketplace. The creation and redemption process helps keep supply and demand in balance, leading to a ETF share price that is generally in line with the value of the underlying securities.

Shares that are created and redeemed are used to fill investors' trades.

Tools of the ETF Trade

This article presents a short overview of the layers of liquidity for an ETF. For a deeper dive into, read our latest publication, Tools of the ETF Trade: Understanding ETF Liquidity and Trading.

You'll learn:

  1. Sources of ETF liquidity
  2. Trade execution considerations
  3. Tips and best practices for trading ETFs

Exchange Traded Funds (ETF) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

The opinions expressed are those of Matt Lewis and are no guarantee of the future performance of any American Century Investments fund.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

For more information on the terms listed above, please see our glossary.

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