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© 2010, Morningstar, Inc. All rights reserved. ETF Liquidity Explained Bradley Kay Associate Director, European ETF Research Ben Johnson ETF Strategist.

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Presentation on theme: "© 2010, Morningstar, Inc. All rights reserved. ETF Liquidity Explained Bradley Kay Associate Director, European ETF Research Ben Johnson ETF Strategist."— Presentation transcript:

1 © 2010, Morningstar, Inc. All rights reserved. ETF Liquidity Explained Bradley Kay Associate Director, European ETF Research Ben Johnson ETF Strategist September 29, 2010

2 22 Agenda × What is liquidity? × How the ETF marketplace works × Why the biggest ETFs keep gathering more assets × Rules of thumb for ETF execution × Outlook for the future

3 33 What Is Liquidity? × The ability to buy and sell a security without moving the price × Factors contributing to greater liquidity × Lots of existing shareholders leads to natural buyers and sellers × General agreement on the value of the security × Ready supply of capital for market makers

4 44 Liquidity in ETFs × Liquidity in European ETFs currently comes almost entirely from market makers who create or redeem shares at the end of day × Requires a slight spread between buy and sell prices, to compensate market makers for the costs of hedging × Market makers are paid to keep spreads at a pre-specified level (typically below 1% or 2% for some less-liquid funds) × Since the market maker has to hedge, the liquidity of ETF portfolio holdings and ease of borrowing capital matter × The largest ETFs move toward liquidity coming from existing shareholders × Allows for the lowest transaction costs, since buyers and sellers are happy to receive fair value

5 5 How an ETF Works ETF Provider Market Maker Stock Exchange Buyer Seller (In-kind transfer)ETF SharesSecurities ETF Shares Primary Market Secondary Market ETF Creation/Redemption Process

6 6 How a Traditional Fund Works Graphic Source: Blackrock

7 77 Liquidity in Traditional Funds versus ETFs × Traditional funds still need to tap the capital markets each day in order to buy and sell portfolio holdings × Not immune from the transaction costs incurred by market makers crucial to ETF trading × Some ability to avoid transaction costs by netting inflows against outflows × ETFs force the purchaser or seller to bear the cost of their trade, while traditional funds spread it among all existing shareholders × Makes the cost of liquidity explicit × Provides the ETF shareholder with a measure of control over their transaction costs

8 88 Why This All Matters × Intra-day liquidity allows you to see the price where you are buying and selling, rather than waiting for the end of day × Allows you to rebalance a portfolio immediately, rather than waiting a day or two to get out of one fund and into another × The creation and redemption process, and the secondary market on the stock exchange that allows it, is the key to ETFs low costs × Only interacting with a handful of major market makers keeps accounting costs minimal × Pushes trading to arbitrageurs and trading firms who can do it for the lowest cost, since they make the market at the margin

9 99 Does It Work? × The arbitrage process keeps market prices for the ETF extremely close to fair value, even as assets change rapidly × If the underlying securities in an ETF are liquid, then the ETF will be as well under the majority of market circumstances × Unlike stocks, new ETF shares can be created, so prices do not get driven up substantially by asset inflows × Example: a new US ETF from entrant Schwab × Intended for retail investors, so inflows came from many sources × Invests in large-cap US stocks, a very liquid underlying market × Assets grew 100-fold, from $2 million to $237 million, in only six months

10 10 Does It Work? Source: Morningstar Direct

11 11 Liquidity Over Time × Liquidity within all securities markets can vary drastically over time × Most visible in ETFs, since their bid/ask spreads make the costs of trading explicit × During market crises, spreads will generally widen as market makers lose access to hedging capital and investors become less certain about fair values × The largest ETFs in the US kept a steady market through the crisis, sometimes providing far more liquidity than their underlying securities

12 12 Dangers of Illiquidity × Typically not much of a problem to buy into a less-liquid ETF × May require more patience if it is not monitored actively by market makers × May require going directly to a market maker × The loss of liquidity during a crisis tends to be steepest for smaller and less liquid ETFs within a category, as these are most reliant on market makers keeping an orderly market × Not saved in a traditional fund, as they still need to sell securities in the vanishing market to meet share redemptions × Costs spread among all existing shareholders

13 13 How to Measure Liquidity × Simple approximations for liquidity × More assets =more potential buyers and sellers × Greater daily volume = more flow, lower margins demanded × Liquid underlying = easy hedging for market makers × More precise measures of liquidity × Bid/ask spread × Depth of order book (XLM) × Premium/discount × Market impact from past trades

14 14 Bid / Ask Spreads × A large component of buying and selling costs for ETFs is the difference between the bid and the ask × Larger ETFs typically have tighter bid/ask spreads < $5 Million Assets> $10 Billion Assets Bid Ask Spread 1.85%0.01% Data as of August 30 th, 2010

15 15 Bid / Ask Spreads × Liquidity costs are a crucial consideration when comparing ETFs tracking similar or identical indices

16 16 Premiums and Discounts × Smaller fluctuations in the past = more liquidity

17 17 Rules of Thumb for Trading × Use limit orders rather than market orders × Does not rely on a deep order book × Allows you to set a fair price for the purchase or sale × Market makers can see your order on the exchange and fill it × Stop-loss orders tend to cause the biggest problems × Drops a market order on the exchange when prices are going down × Tends to place a sell order precisely when liquidity is lowest × Led to major losses in the May 6 Flash Crash in the US × Circuit breakers on European exchanges will keep losses smaller, but not prevent them entirely

18 18 ETF Trade Execution Gone Wrong × ETF with nearly $1 billion in assets under management × Relatively strong liquidity in the secondary market

19 19 ETF Trade Execution Gone Wrong × Too large of a market order for the immediate liquidity on the exchange × Market makers do not always want to post their full order size on funds that they are not constantly monitoring × This order executed at a variety of prices, with the peak being 19% above fair value × After the market order went through the books, the bid immediately came back down to near the fair value of the ETF × Could have been avoided by using a limit order × Look at iNAV to see what fair value of the portfolio is × Bid, ask, and recent trade prices also give a good idea of the current fair value

20 20 Fair Value Pricing × The iNAV is not always accurate × Foreign stock ETFs trade in Europe even when the underlying markets are closed × Events can arise when local markets are closed that will impact valuation once trading opens, but iNAV may not incorporate that change in value × Market makers rely on futures, local listings of foreign shares, demand changes, and proprietary algorithms to determine a securitys fair value × If a large number of trades are occurring at fairly tight spreads, that suggests a reasonable market price even if it differs from iNAV Graphic Source: Vanguard

21 21 Trading Best Practices × Use limit orders × Avoid stop-loss orders × Evaluate the market × Indicative values × Recent trade prices × Bid / ask quotes × Avoid trading during extreme volatility (Flash Crash) × Trade when the underlying market is open and functioning

22 22 The Future for European ETF Liquidity × Most investors are still large, slow-trading institutions × Even the highest volume ETF in Europe only trades about £50 million per day through the exchange, less than 1/250 th of the volume traded through SPDRs (the worlds largest and most liquid ETF) × The market is still reliant on market makers and could face some trading disruptions in another major crash × Liquidity is growing rapidly × Hedge funds are shifting toward using ETFs in place of OTC derivatives from investment banks × Retail investors and advisers are starting to buy off LSE, Deutsche Börse, and Borsa Italiana

23 23 ETF Liquidity is Growing Rapidly × Year-to-date trends through August are encouraging × Though the trend is positive, there is still a long way to go

24 24 The Future for European ETF Liquidity × ETFs pulling in the greatest amount of assets and putting up the largest volumes will continue to succeed × Lower trading costs mean a lower total cost of ownership × More purchasing across the European exchanges × A spread thats only one penny tighter on a £10 share is worth £100 on a £10,000 trade × Biggest ETFs will keep their liquidity even during a crash × Likely to end up as one of the lowest-cost ways to trade illiquid asset classes like fixed-income and foreign markets during a crisis

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