Active ETFs: Low Volume Active ETFs Are Not “Illiquid”

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In May 2010, ActiveETFs | InFocus spoke with Paul Weisbruch, who is the VP of ETF/Index Sales and Trading at Street One Financial. Street One Financial is an ETF liquidity provider and works with advisors in helping them access liquidity and trade ETFs efficiently. Paul chats with us about a fundamental misconception about ETF liquidity, how investors can trade efficiently in seemingly illiquid ETFs and the creation/redemption process.

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Shishir Nigam – ActiveETFs | InFocus: Paul, welcome to Active ETFs | In Focus and thanks for joining us.

Paul Weisbruch – VP, Street One Financial: Thank you and glad to be here.

Shishir: To start off, could you tell us a little about yourself and what role Street One Financial plays in the ETF world?

Paul: Certainly. Street One Financial functions as an agency liquidity provider. I would make the distinction between agency and principal, in that there are a few participants in the market that are market makers. Sometimes they’re authorized participants (APs) as well and in essence they trade against customer order flow. They calculate their price, the underlying basket, factor in the commission and/or mark up on the trade and then trade against customer positions. Now that is an essential part of the creation of liquidity. However, the way we benefit investors is that we find the absolute best price in the market at a given point of time. And in doing that, we have a pretty robust network of liquidity providers as well as a mechanism to trade the ETFs ourselves in the open market. We feel that our model works because we can give people and unbiased opinion on where we think the ETF should be priced and we’re charging the same commission each and every time. So it behooves us to get people a superior price as opposed to an inferior price.

Shishir: Could you briefly explain the creation and redemption process for Actively-Managed ETFs?

Paul: Sure, the creation/redemption process for Active ETFs is exactly the same as it would be for any ETF, even a passive, index ETF. What happens is, the first day an ETF is listed, it will only have a certain number of shares outstanding, generally a few hundred thousand shares is standard. Now, by no means does that mean that an investor can’t go and buy a million shares. ETFs are open-ended index funds regardless if they’re active or passive – it’s the nature of an ETF wrapper. So there’s a reason that managers pursue an ETF structure as opposed to a mutual fund or closed-end fund, and that’s to have unlimited flexibility in the number of shares that can be issued. When an investor wants to buy more shares than are outstanding or shares that are a large multiple of the average daily trading volume of that ETF, they simply buy the shares in the open market. Or conversely, they can actually order a creation unit from the custodian bank. I’d be happy to talk about the reasons why you would choose one route over the other. It largely does not affect anything in the underlying basket as far as adverse price effect. And that has everything to do with the fact that these are open-ended index vehicles and the managers of them have chosen a pretty broad robust index that most of the time can handle millions if not billions of dollars without affecting the underlying prices. On the flip side for redemptions, when someone has a large position in an ETF and they need to liquidate it, they should take comfort in the fact that they can get out of a position without impacting the price significantly, if trading the right way. Largely, the creation and redemption process is happening behind the scenes between the authorized participant and the trading firms and the custodian banks – like State Street, Bank of New York and so forth. It’s not something the average investor has to worry about. You’re generally buying or selling your shares in the market at the time of your order. The creation/redemption happens after the fact, after market hours and I find a lot of people get wrapped around the methodology of creation and redemption and it prevents them from really understanding the core of what they should be doing – and that’s how to trade the ETF optimally without moving the price.

Shishir: You mentioned the term “authorized participant”. Is there a difference between a “market maker” and an “authorized participant”?

Paul: Yes, there’s a fine distinction between the two. Some authorized participants may not be market makers in a given ETF. And some market makers may not be authorized participants (APs), that’s one caveat. However, there are some firms that act as both market marker and authorized participant. Really, it varies from firm to firm and ETF to ETF. Both participants though are essential to the liquidity and the open-endedness of ETFs and the mechanics that make them trade efficiently. Authorized participants are the ones who can actually trade the underlying basket versus the ETF itself and then they would convert those to new shares and vice versa would redeem them if someone was coming to them with a sale. So they actually have permission and have gone through a filing and paperwork with the ETF company themselves, whether it be iShares, ProShares, First Trust, what have you, to have permission to be an AP. So there’s a handful of APs out there and mostly they are the large banks – the usual suspects like the Merrill Lynch’s, the Morgan Stanley’s, Fortis Bank, Goldman Sachs, firms like that tend to be the APs. Market makers, however, there’s a large number of market makers that are not APs. I would venture to say 40 if not 50 firms, that you probably haven’t heard of because they are basically electronic, prop-type trading market makers. They’re very active in the underlying liquidity of ETFs, they are making two sided markets, bid-ask, and sometimes they’re just waiting for someone to come to them with an order and they’ll price it for you. Again, they have little interest in the whole creation/redemption process because they’re just trading, looking for small inefficiencies, trying to trade the underlying versus the actual ETF shares that are out there in the market.

Shishir: Could you explain what the fundamental difference is between the liquidity of a stock versus the liquidity of an ETF?

Paul: Certainly. First and foremost, the liquidity of a stock is a supply and demand market and thus subject to security specific news and events. So if you’re trading IBM or if you’re trading Google, that price, from tick to tick, is determined by if there’s a buyer or seller around in the stock. And obviously, news, market-related or stock-related, moves that stock higher or lower throughout the day. With an ETF, the first thing to remember is that there is always more than one underlying component. Generally there’s dozens if not thousands of underlying securities in the ETF. And that said, any specific news about any given stock or any specific news about the market generally dampens the effect on that ETF’s price volatility on the whole. Now there are a few ETFs, they might only have 20-30 underlying names, but as you can probably understand, if a billion dollars comes into a market in any given stock, the price impact could be a lot depending on the given stock, especially if it’s a small-cap name. If a billion dollars comes into an ETF, that represents say the Wilshire 5000, the price effect will be muted and nil most likely because that’s a broad-based index that can handle billions of dollars of inflows or outflows without any noticeable price impact. This is kind of lost on people because people look at trading volume as their metric and are extrapolating the same logic they use to trade stocks, incorrectly into ETFs.

Shishir: The ETFs still though have a bid/ask spread. So what does the size of that bid/ask spread depend on for an ETF? When would it widen?

Paul: It generally widens when there’s a lack of market makers watching the product and you’ll see this on newer ETFs. ETFs do require a certain amount of seasoning for the market maker community. Not every market maker will jump into a product and make markets actively on day one. So therefore you might see a 10 cents wide spread in a newer ETF because maybe there’s only a handful of market makers in it while in SPY and IWM, there may be hundreds of participants actively involved in it and watching it all day long. But make no mistake, just because it has a wide spread does not mean it can’t be traded effectively. That bid-ask spread should be around the real NAV or IV of the fund at any given point of the day and that’s what’s important to understand. The bid-ask is not necessarily what you’ll pay or what you’ll sell for if you have an order. It’s kind of a framework around the actual IV, so if you trade intelligently, use limits, have some idea what the NAV or IV is, you should generally do better than the actual bid-ask.

Shishir: Finally, how can a retail investor trading through a discount brokerage ensure he gets proper execution when trading in a low volume Active ETF?

Paul: Sure, I think knowing how to calculate the IV, especially for equity ETFs is very helpful. Now, on Google or Reuters or Bloomberg, generally the syntax is the ETF symbol + .IV. In other words, SPY.IV would be an example for Spiders. I do want to caution this is very accurate for US domestic equity-based ETFs, because all the underlying holdings trade during US market hours. Whereas, if you try to value something that is based in China but trades on the US market, you’ll always see a premium/discount issue because the underlying basket stops trading at a certain time, even though the US is open. So, if people think they’re getting a raw deal because they’re paying a premium in a China-based or India-based ETF, that’s not necessarily true, it’s just that there is a difference between the underlying basket that stopped trading and what’s reflected in the US market. A lot of people shy away from fixed-income ETFs for the same reason, because they look at NAV versus bid-ask and think that, “Oh, there’s a premium or discount, I don’t want to trade this product”. Again, it’s not as vanilla as a US equity product. So for anything non-US equity related, I would say use your IV as a benchmark, as some parameter of where you should be executing yourself. And try limit orders or use marketable limit orders to ensure you’re not getting run over by sending market orders. Under no circumstances should you send a market order. I’ve seen people give away pennies if not more than that in bad execution by sending market orders. If nothing else, use a marketable limit because then you have price protection on both sides of the order.

Shishir: That’s fantastic. Thanks a lot Paul for joining us and we wish you all the best.

Paul: Great, well thanks very much. And anytime, anyone has any questions, I’ll be here.