16 May 2012 | Volume 3 | Issue 13

The Blotter presents ITG’s insights on complex global market structure, technology, and policy issues.

CONTRIBUTORS

Milan BorkovecHead of Financial Engineering Milan.Borkovec@itg.com617.692.6733

Vitaly SerbinManager of Financial Engineering’s Portfolio Analytics Research Group Vitaly.Serbin@itg.com617.692.6746

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Asia Pacific +852.2846.3500

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info@itg.com www.itg.com

Lifting the Veil From ETF Liquidity What You Need to Know to Appreciate What You See

Exchange-traded funds (ETFs) are relatively new investment tools that are similar to mutual funds, but trade more like stocks. Some of the most popular ETF strategies, such as cash equitization and hedging, rely extensively on accurate index tracking, abundant liquidity and low cost. In fact, according to a Greenwich Associates survey, 61% of institutional funds and 79% of asset managers cite liquidity as one of the top ETF selection criteria1. As a consequence, understanding and managing the ETF trading process is crucial. Failure to tap available ETF liquidity, or to fully understand the nature of ETF costs, would severely limit the usefulness of an ETF in a typical buy-side investment application.

In this new research study, we examine twelve popular ETFs and show that these ETFs exhibit qualitatively very different liquidity and cost characteristics than common stocks with similar daily share volume, price, spread and volatility. We discuss the reasons behind these differences and explore the role of the creation/redemption mechanism. Some of the questions that are being answered are:

• How do the limit order books of ETFs and common stocks compare?

• Does trade execution of an ETF matter? And if yes, what are the differences in costs of an ETF when trading instantaneously, using optimal trading scheduling in the second market and/or executing via creation/redemption?

• When does the creation/redemption process add value in executing ETFs? How much does it add value?

• Are there differences in trading costs for ETFs that track the same or similar indices? And if yes, how important is the liquidity of an ETF on the secondary market?

• Do issuers of ETFs differentiate their products in terms of accessing liquidity?

In what follows, we discuss the main findings of the research2.

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1Greenwich Associates, “Institutional Demand for Exchange-Traded Funds Continues to Climb”, May 2011.2More details can be found in the paper “Create or Buy: A Comparative Analysis of Liquidity and Transaction Costs for Selected U.S. ETFs”.

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All ETFs in the sample demonstrate qualitatively similar limit order book (LOB) liquidity characteristics:

• The LOB of an ETF is deeper and more concentrated around the prevailing mid-quotes than the LOB of a matched common stock3.

• The costs of instantaneous execution (climbing up the book) are significantly lower for ETFs than for matched common stocks.

• The LOBs of ETFs are quite volatile: the number of ETF units that can be traded instantaneously at any particular moment of time can change dramatically within a single trading day.

The differences in the limit order book liquidity spill over to the differences in transaction costs estimates calculated assuming optimal trade scheduling using ITG’s new Smart Cost Estimator (SCE) during the entire trading day4. The key points are:

• The creation and redemption mechanism is crucial for accessing ETF liquidity for large order sizes. While the creation/redemption costs are lower than the corresponding ETF costs for only the Vanguard ETFs VOO, VO and VB for a $10mln trade, the picture changes completely for a $100mln trade. 10 out of 12 ETFs have creation/redemption costs that are cheaper than trading the same quantity on the secondary market.

Cost Estimates (in bps) for $10mln and $100mln ETF Trades5

Cost of optimal trading, $10mln Cost of optimal trading, $100mlnETF Matched

common stock

ETF basket (fee included)

∏ETF Matched

common stock

ETF basket (fee included)

VOO 2.1(53)

12.5(-)

1.9* 4.0(-)

30.5(-)

1.7*

IVV 1.1(1.6)

4(98.2)

1.9 2.9(-)

19.5(-)

1.7*

IWB 1.4(5)

5.6(93.3)

2 3.1(-)

19.8(-)

1.7*

VO 5(105.7)

16.2(-)

2.7* 9.1(-)

38.4(-)

2.8*

IJH 2.6(8.1)

6.1(-)

2.9 7.4(-)

21.9(-)

3.8*

VB 4.8(63.8)

13.8(-)

3.7* 10.9(-)

35.3(-)

4.2*

IJR 2.5(40.9)

5.8(-)

3.8 8.0(-)

21.7(-)

6.3*

RSP 2.2(21.1)

11.6(-)

4.2 6.2(-)

29.2(-)

2.2*

IWM 1.5(2.7)

4.1(58.7)

4.3 5.1(-)

23.1(408.5)

5.2

SPY 0.6(0.8)

3.7(33.9)

5.1 1.9(2.5)

17.6(297.3)

1.9

MDY 1.4(3.9)

4.3(-)

6.1 4.6(-)

20.7(-)

4.0*

IWC 9.2(-)

20.2(-)

9.8 17.6(-)

48.2(-)

16.2*

3For details on the matching procedure see the original paper. 4SCE uses as its inputs the order attributes (size, date, and time stamp), security characteristics (type, expected liquidity, volatility, and daily average spread), recently observed market conditions (deviations of volatility, volume, and spread from historical patterns), and the traders’ subjective market sentiment and its persistence (expressed through the magnitude of trade imbalance). In contrast to a static trading cost estimator, the SCE model has the capability to dynamically update execution trajectories based on the market response to order flow and the observed market conditions.

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• Liquidity on the secondary market remains important for certain ETFs. For example, SPY, as well as IWM, have enough instantaneous liquidity in their order books for trading 85 and 21 ETF units (or $580mln and $85mln), respectively, and their implementation shortfall costs are very low, in general.

• Overall, ETF providers seem to be fully aware of the advantages and disadvantages of their products with respect to liquidity provision, and try to position them within a suitable market niche. For instance, SPY, IWM and MDY rely almost entirely on the secondary market liquidity, whereas the Vanguard products offer cost-effective creation/redemption options.

• The arbitrage mechanism available to authorized providers pushes down the secondary market ETF costs. The figure below presents the trading cost estimates for five different ETFs that track U.S. large cap indices. The solid lines depict cost estimates for trading ETFs on the secondary market and the dashed lines show the costs for trading the underlying baskets (incl. creation/redemption fees). The cost curves illustrate that the costs of trading these five ETFs on the secondary market are much closer than what one would anticipate when considering their secondary market liquidity only.

SCE Estimates for Large Cap ETFs

• Looking jointly at the cost estimates of ETFs and the underlying baskets provides additional clarity with respect to the “true” cost of an ETF. We argue that these cost estimates can be utilized to derive upper and lower bounds of the “true” average costs. These bounds could be interpreted as limits to arbitrage that could be performed by authorized participants.

5Notes:a. The rows are sorted in ascending order by the SCE basket cost estimates in the fifth column, i.e. the cost estimates of trading $10mln worth of the constituents of an ETF (marked with ∏). The cells with an asterisk indicate that trading the basket is, on average, cheaper than trading the ETF on the secondary market.b. The values in parentheses denote the average costs of instantaneous execution (climbing up the book). The “-” values indicate that there is insufficient available visible depth in the LOB on average to execute the specified quantity.

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• We caution that the indiscriminate use of market orders (the red dashed line on the chart below) can void the advantages that the creation/redemption process offers when sourcing additional ETF liquidity. At the same time, a good broker can reduce the actual costs of trading an ETF, via the creation/redemption mechanism, to the lower limit (the green dashed line on the chart below) of the “true” average costs.

SCE Estimates for Different Trading Styles: VB

• A good transaction cost model is indispensable in quantifying cost-effective ways of trading ETFs. ITG’s Smart Cost Estimator (SCE) model recognizes that ETF trades have smaller permanent price impact costs than common stocks with similar daily share volume, price, spread, and volatility characteristics. SCE parameters are estimated and calibrated using the ETF-only sub-universe of ITG’s Broker Peer Group database. In addition, it also consolidates the entire accessible ETF liquidity on the secondary market and through the creation/redemption procedure.

©2012 Investment Technology Group, Inc. All rights reserved. Not to be reproduced or retransmitted without permission. 50312-22039

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