Who are the key players?
The ETF market is actually made up of two markets – a primary market where ETF shares are created and redeemed, and a secondary market where ETF shares trade on an exchange or over the counter with a market maker or an ETF trading desk.
Here are the key players in each market:
ETF managers manage the ETF and its portfolio of securities.
Authorised participants (APs) are the institutions authorised to interact directly with an ETF manager to create and redeem large blocks of ETF shares.
Market makers and liquidity providers provide intraday liquidity for securities on the stock exchange. They compete for orders by publishing bid and ask quotes for a number of shares.
ETF trading desks help ensure that large ETF trades are executed efficiently. They are able to find liquidity in an ETF regardless of its average daily volume or the liquidity shown on the trading screen.
Investors buy and sell ETF shares on an exchange at an agreed-upon price.
Where do ETFs get their liquidity?
It's a common misconception that an ETF's liquidity is best gauged by its average daily volume (ADV).
The reality is more complex. That's because ETFs get most of their liquidity from sources other than their trading activity on the stock exchange. Most important of these is the liquidity from an ETF's underlying portfolio of securities. The main sources of ETF liquidity are:
The most visible source of ETF liquidity is the trading activity of buyers and sellers in the secondary market that takes place on an exchange. The average daily trading volume (ADV) is a measure of this activity, but it doesn't indicate an ETF's total liquidity.
Not all of an ETF's liquidity in the secondary market is easy to see. If you're a typical investor, your "on screen" view is probably limited to what's available through public financial websites. This means you'll have access to an ETF's highest bid and lowest ask, but you won't be able to see all the quotes in an ETF's order book. These quotes are another source of ETF liquidity because they represent additional prices at which ETF shares can be traded.
An ETF’s liquidity can be hidden in other ways too. In Europe, many ETFs trade on more than one exchange. So your “on screen” view may display an ETF’s trading volume on the London Stock Exchange but not show its volume on other exchanges such as Euronext or the SIX Swiss Exchange.
Some ETF trading activity, called over-the-counter (OTC), takes place off exchanges altogether. This activity is sometimes not reflected in the volume data provided by stock exchanges. OTC liquidity, however, is an important source of ETF liquidity. Most ETFs are traded by multiple market makers. Those market makers might have inventories or can use their balance sheet to fill ETF orders.
Liquidity from underlying securities
The key to ETF liquidity lies in ETFs' open-ended structure. Unlike single stocks, which have a fixed supply of shares, new ETF shares can be created and existing shares redeemed based on investor demand. This unique process allows ETFs to access the liquidity of their underlying securities. The result is that investors can often trade ETFs in amounts that far exceed an ETF's ADV, without significantly affecting the ETF's price.
What are common order types?
ETFs allow you to place any type of trade that you would with equities. Here are some common order types:
You buy or sell immediately at the best available current price. When you place a market order, your priority is making the trade quickly, not securing a particular price.
You set a price – the stop price – at which you automatically buy or sell. When the market hits the stop price, your stop order becomes a market order. The price you then get is the best available current price. That price may have changed, for better or worse, in the moments after your stop price triggered your market order. When you place a stop order, your priority is trying to limit a loss or protect a profit.
You set a price and execute your trade only if shares are available at that price or better. Limit orders protect you from executing a trade at an undesirable price. When you place a limit order, your priority is securing a certain price, not speed of execution.
Similar to a stop order, but in addition to setting the stop price, you also set a limit price. When the market hits the stop price your stop order becomes a limit order, at the limit price you specified. When you place a stop-limit order, your priority is trying to limit a loss or protect a profit without the unpredictability of a market order.
Your ETF trading desk can help
An ETF trading desk, if one is available to you, can use its trading tools and network of relationships to help you when you place a large order. Your ETF trading desk may be able to:
- Review the depth of interest in an ETF before placing a trade. You may be able to determine from your trading screen only how many shares are available at best-bid and best-ask prices. Your ETF trading desk can evaluate additional availability of shares.
- Trade in increments to manage any effect that large trades could have on prices.
- Create and redeem ETF shares directly with the ETF manager, if your broker is an authorised participant.
- Obtain a quote to execute the entire trade.
A Vanguard sales representative is a good starting point for a discussion about ETF liquidity. He or she can consult with one of our capital markets specialists on your behalf, or refer you directly. The specialist can access additional data on the depth of liquidity and suggest a trading execution strategy.
For larger trades, the specialist can consult with market makers to help you maximise potential liquidity in the ETF. The Vanguard capital markets specialist will know whether your requested trade size is large enough to engage a market maker or whether liquidity is naturally available for your order. A large order for one product may not be a large order for another.
How do I place an order?
A number of factors can influence how you place ETF orders and when you should call an ETF trading desk for assistance.
Here are two common scenarios, along with some practical tips that will help you place ETF orders quickly and confidently.
You want to execute your trade right away
Whether you want to lock in a current market price, avoid adverse market movements or simply execute your daily trades and move on to other priorities, the key to determining your trading approach is understanding the effect of trading volume.
If the ETF you want to trade has a high average daily volume (ADV) you can execute a simple limit order through your trading site. However, when you want to place an order for an ETF with a low ADV, it may be better to contact your ETF trading desk.
Keep in mind that your ETF trading desk has access to an extensive network of liquidity providers that can help place your order and execute your trade, especially in low-volume situations.
You want to work an order over time
When your objective is to place an order for the best possible average trade price over a period of time and the ETF in question is trading at a high ADV, your best option is to have the ETF trading desk work the ETF order.
When your objective is the same, but the ETF is trading at a low ADV, your ETF trading desk can assist with more sophisticated order and execution strategies, including:
- Time-weighted average pricing (TWAP), which provides an average price of a security over the course of a specified time.
- Volume-weighted average pricing (VWAP), which provides an average price of a security based on its trading volume across various price points.
TWAP and VWAP orders ensure your trade will be executed not at the lowest or the highest price but at an average of the two during the specified period of time.
Be aware of special circumstances
There are occasions when executing a large order for an ETF may have a market impact. Under this circumstance, your ETF trading desk can be especially helpful by transacting with multiple brokers and generating a level of trading competition that can result in a favourable trade.
How do premiums and discounts work?
An ETF typically trades at a price that's close to the net asset value (NAV) of its underlying securities.
However, due to factors such as trading hours and market liquidity, an ETF's market price might be higher or lower than its NAV.
- Premiums. When an ETF trades at a price that is higher than its NAV, it is said to be trading at a premium.
- Discounts. When an ETF trades at a price lower than its NAV, it is said to be trading at a discount.
Authorised participants (APs) help to keep the ETF's market price in line with the value of its underlying securities. If a significant premium or discount develops, an AP can capitalise on the price difference through the ETF creation/ redemption process. Creations and redemptions help to bring the supply of ETF shares more in line with demand, which in turn helps to bring the ETF's market price more in line with the value of its underlying securities.
Drivers of ETF premiums and discounts
The appearance of premiums and discounts is a natural outcome of the relationship between the supply and demand of ETF shares and the underlying securities.
Two additional considerations surrounding premiums and discounts:
- If the cost of buying the underlying securities is higher, the result may mean a wider range of premiums and discounts.
- If the underlying securities trade on an exchange that is open at a different time than the exchange the ETF trades on, there could be deviations between current and stale security pricing, resulting in perceived premiums or discounts.
ETFs in some asset classes – for instance, fixed income – tend to have relatively large and constant premiums and discounts. A major reason for this occurrence is the pricing difference between the ETF and the underlying bonds.
Figure 1. Pricing differences can lead to an inherent premium for bond ETFs
A US corporate bond ETF's end-of-day market price is calculated as the midpoint of the best bid and offer at 4 p.m., US Eastern time, while the underlying bonds in Vanguard ETFs are valued at their bid prices (Figure 1). This pricing difference results in an inherent premium since the midpoint of the bid-ask spread on the ETF is typically going to be higher than the bid price of the underlying bonds.
The level of premium or discount will also vary depending on the demand for the ETF relative to the flow in the market. The greater the relative demand to buy the ETF, the higher the bid-ask quote and thus the higher the midpoint of that quote (Figure 2). This could result in a larger premium. The opposite is also true: If there is greater demand to sell the ETF, its premium could fall and perhaps result in a discount.
Granted, bond ETF premiums and discounts can be somewhat misleading because transaction costs are more transparent with ETFs than with traditional mutual funds. In times of heavier order flow or less liquidity, the bid-ask spreads of underlying securities could widen to reflect the current market situation, leading to larger premiums and discounts for bond ETFs. A mutual fund portfolio manager trying to buy or sell the same basket of bonds may also be paying the same bid-ask spread. However, investors do not see those costs in real time; the costs manifest after the fact as part of the fund's NAV. To put a fine point on it: Premiums and discounts in bond ETFs are largely a reflection of the externalisation of investors' transaction costs.
Points to consider
The spread on the underlying holdings has a clear impact on premiums and discounts, since it determines the ETF's trading range. Here are some considerations across asset classes:
Government bonds tend to be liquid, with narrower and more consistent bid-ask spreads, causing government bond ETFs to trade with smaller premiums and discounts. Corporate bonds tend to be less liquid, with wider and often more volatile bid-ask spreads. As a result, corporate bond ETFs tend to have larger premiums and discounts.
Large-capitalisation shares tend to have narrower spreads, causing large-cap ETFs to trade with fewer premiums and discounts. Small-cap shares tend to have wider spreads, causing small-cap ETFs to have relatively larger premiums and discounts.
What are some best practices for trading ETFs?
By following a few best practices, you can help achieve favourable prices for your ETF trades.
Use limit orders
Limit orders let you determine the maximum or minimum price at which you’ll execute an ETF trade. While limit orders offer you control over price, there is always some risk that your order won't be fully executed.
Market orders can be effective when you’re buying or selling ETFs with significant liquidity and narrow spreads. However, since the overriding objective of a market order is trade execution rather than price protection, it’s possible you will receive an undesirable price for your trade.
Consider market volatility
Be wary during volatile periods or when there are major events that affect markets. Market volatility can cause the prices of an ETF's underlying securities to move sharply, which can in turn cause the ETF's shares to have wider bid-ask spreads or larger premiums or discounts. Limit orders may be beneficial in such situations because of the price protection they provide.
Keep abreast of the news
Investors should pay attention to market news as ETF prices may swing in response to the release of economic indicators or statements from central banks, as well as earnings and other news from companies that are large constituents of an ETF.
A common misconception is that ETFs with lower average daily volume (ADV) are not as liquid as others in the marketplace. ADV is generally a good gauge of liquidity for a single stock because the number of its outstanding shares is generally fixed. However, ETF shares can be created or redeemed through an authorised participant, so the liquidity of the ETF's underlying securities is what matters most. When the underlying securities are difficult to trade, it can result in a wider bid-ask spread for the ETF. Learn more.
Heed the clock and the calendar
Spreads can widen at certain times each day or on certain days of the year.
At the market's open, some of an ETF's underlying securities may not have begun trading, which means a market maker can't price the ETF with certainty.
At the market's close, fewer firms may make markets in an ETF as market participants try to limit their risk, so fewer shares may be listed for purchase and sale than at other times of the day.
When international markets are closed, spreads can widen for European-listed ETFs that invest primarily in securities that trade on exchanges with different opening hours, for example, a Japanese equity ETF that trades on the London Stock Exchange. If you're trading an ETF that invests internationally, it's helpful to know the market holidays of the relevant overseas exchanges.
Use an ETF trading desk
An ETF trading desk, if one is available to you, can use various trading tools to help you source liquidity for a large order.
Learn the basics of ETFs, including their history, how they compare to mutual funds and more.
Learn about the different types of exchange-traded products, how index and active ETFs are managed and more.
Learn about strategic and tactical uses for ETFs, including portfolio completion, liquidity management and more.