Primary market liquidity is something mutual fund investors are likely familiar with. This liquidity pool is facilitated by the creation & redemption of ETF shares. When investors purchase a mutual fund, the transaction is settled with a creation of new mutual fund shares. In the primary market for an ETF, shares are created & redeemed with this same mechanism. The key difference is that investors have the flexibility to access these shares intra-day with an ETF versus just the end of day with a mutual fund. Investors can access primary market liquidity by simply phoning their broker for a block trade.
Secondary market liquidity is something that equity investors are familiar with. This is the on-exchange trading activity of an ETF. The vast majority of U.S. ETFs are listed on NYSE Arca, and trade during U.S. hours across U.S. exchanges. Numerous liquidity providers actively participate in ETF markets by quoting shares on these exchanges. This allows for investors to purchase or sell shares by simply placing an order with their broker.
A common misconception is that secondary market liquidity is a constraint on daily trading volume in an ETF. In fact it is quite common to see trades in many multiples of average daily volume executed with no impact on the market. This is due to the deep primary market liquidity in ETFs, as investors have access to primary market ETF shares.
Primary market liquidity is a function of the average daily volume of the ETF’s underlying securities. For developed market funds, the primary market liquidity pool can be in excess of $1bn per day. That is, $1bn worth of ETF shares could be created without impacting the underlying securities. Common practice is to measure primary market liquidity with a metric called Implied Liquidity.
Implied liquidity is the trade size in an ETF that would start to move the market for the ETF’s underlying securities. Convention is to calculate implied liquidity with the 25% rule. That is, what is the size trade in the ETF that would become more than 25% of the average daily volume in the least liquid underlying security. This is not a ceiling on the amount of ETF shares that could be traded at once, but above this point it might be best to spread the trade over multiple days.
Secondary market liquidity is best measured with on average 20 or 30 day trading volume on exchange. Other useful metrics when analyzing secondary market liquidity are spreads and market depth.
There are a few guidelines we recommend when trading ETFs. When trading in the secondary market, it is best to place limit-orders rather than market orders. Limit-orders place a ceiling on the execution price for an ETF while market orders can be filled at any price. In times of thin liquidity, or if a large order from another investor is placed prior to your market order, your execution could be poor.
Stop-loss market orders should also be avoided. These orders convert to market sell orders when an ETF falls below a certain price level. This largely contributed to the ETF flash crash on August 24th. In place we recommend the use of stop loss limit orders which work similarly but put a floor on the sell execution price .
Please feel free to call the Capital Markets Desk if you have any questions with trading in the Xtrackers ETFs.
It is best to trade when liquidity providers are most active as this provides the best market depth. With exception of the open and close, liquidity can be sourced at all points during the U.S. market session. Liquidity can be thin at the open and close and thus we recommend avoiding trading during these times.
When trading international equity ETFs, despite the underlying markets being closed during U.S. hours the ETF should trade in line with fair value so it is not necessary to time trading around international market hours.
The most active market maker in a fund will vary from product to product. Best practice would be to contact the Capital Markets Desk to connect you with the most active market maker for your specific order.
For international equity ETFs there should be a perceived premium/discount in the ETFs price versus its NAV. This is due to the timing difference between international and U.S. market hours. For example, a U.S. listed European equity ETF will trade from 9:30am to 4:00pm EST. In the morning there will be a period of overlap in which U.S. and European markets are trading. During this time, the ETF will trade directly in line with the current value of its underlying holdings. When these underlying markets close however, the ETF will become a price discovery vehicle for the fair value of its underlying securities, trading in line with European futures. This will cause a perceived difference from the end of day ETF NAV, which will be valued from the closing prices of the underlying securities.