Never thought about this much before but recently I’ve been wondering - I know some ETFs work of swaps with larger banks, so that makes sense. But are these the majority?
Some of those small cap ETFs have to hold some underlying crap that only trades like 10-20k shares a day, when the ETF might trade millions of shares. You never see the volume in the stock, so how does the ETF get away with it if it is not a swap based ETF?
Didn’t see a clear explanation when I looked for 5 minutes online.
On the fixed income side, this is accomplished by altering the redemption baskets to something that is “close enough.” Also keep in mind that just because an ETF trades, doesn’t mean that the underlying stocks trade. If I buy a share of SPY from you, that doesn’t affect anything else in the market. I forgot the exact statistic, but the ratio of ETF trading volume in AGG to the trading volume of the actual bonds in the ETF was something like 5:1.
The liquidity mismatch was great in 2008. You could straight up arbitrage the bond ETFs. This is one of the reasons I belief ETFs are going to seriously burn some investors. Also, witness August 24th this year.
I don’t know about 20K shares a day but if you look at a
It will all end badly.
Anyone read the new proposed rule by SEC which impacts the ability of ETFs and mutual funds to hold illiquid securities? I just got an email from Factset today about it
I did see that. Doesn’t really clarify anything as far as I could tell though. You still have gray area in regards to how you affect the price when liquidating I believe.
Could you explain further? I assume this means at the end of the day when it is seen how many shares of the ETF have been bought or sold they they trade that amount of stock? Does the owner of the ETF do this internally? In this case wouldn’t they have to hold a crapton of each stock?
To me that’s the only way it makes sense.
I thought the ETF holds a basket of stocks and just swaps ownership of that basket without increasing/decreasing exposure to the basket?
Isn’t that a fundamental difference between ETFs and mutual funds?
ETFs grow when investors buy more than they sell. They are similar to MFs in this way. Not many ETFs start with $100M+ in assets and have to grow from a base of $2-$10M. This is why new ETFs are marketed so hard because they won’t survive unless you help grow them.
WHAT’S A MARKET MAKER?
Market makers, also known as designated brokers, are essential to the smooth functioning of the ETF marketplace. Their role is to maintain liquidity by offering to buy or sell ETF units when nobody else will, and also to set the “goalposts” for the bid and ask prices
“The market maker is very much like a shopkeeper, but he operates on two sides of the market. So you can buy from him and sell to him,” explains Oliver McMahon, director of product management for iShares Canada, owned by BlackRock Asset Management Canada.
The market maker’s bid (the price at which he’ll buy) and ask (the price at which he’ll sell) are based on the underlying bid and ask prices of the securities in the ETF, plus a small profit spread (usually a fraction of a percentage point). Other buyers and sellers usually trade at prices within these goalposts.
In effect, market makers - usually one of the bank-owned investment dealers - provide a second layer of liquidity in addition to the normal supply and demand from investors. Without market makers, the ETF’s price could get seriously out of whack with the price of the underlying securities.
HOW ARE ETF UNITS CREATED?
Say you’ve got $1-million and you decide to invest in an ETF, but the market maker doesn’t have enough units in inventory to fill your order. No worries: He can whip up a fresh batch of units for you.
When your order arrives, the market maker credits your account for the units. His computer system then purchases $1-million worth of the underlying stocks in the ETF.
In broker parlance, the market maker is now “short” the ETF units (because he sold them to you without actually owning them) and “long” the underlying stocks (because he bought them).
He then delivers the underlying shares to the ETF company, which in turn issues him $1-million of new units, thereby cancelling his short position.
See MLA’s response regarding creation units. That’s what happens when a ton of the ETF is either bought or sold, or there is not enough liquidity in the market to support a large order. I think for most ETFs the unit size is $100k. It also keeps the ETF price relatively close to NAV, because brokers will arbitrage it. What I was saying is that ETFs have liquidity like any other stock. If I want to buy 100 shares and someone else wants to sell 100 shares, the trade executes at a fair price and nothing happens to the stocks in the ETF basket. The same number of units exists, the total ETF assets haven’t changed, etc.
So what? ETFs traded at discounts for days in March 2009. We all survived. Felt like Christmas to me. Closest thing I have ever had to a religious experience was the night after going 4 to 1 leverage on March 9th, 2009. Can we have another please? For most traders, ETFs remained liquid, but not for the largest. Yeah, the spreads increased a little. Cry me a river.
And what most of you are talking about is not liquidity. bromion touched on it. Liquidity is dependent on the size of the desired trade. Liquidity is relative. If a security can absorb your trade, without that trade causing a significant change in price, that security is liquid as far as you are concerned. In March of 2009, the size of the orders spiked, The idea that any security should be able to stay liquid for any size trade is ridiculous. As MLA mentioned, there is a little risk in unit creation and cancellation. In March 2009, substantial payment was required to take on that risk.
All this concern about bond ETFs and the like is blown out of proportion. Yeah, if you want out at a time of your choosing, your loss my be larger than you anticipated. Deal with it. I would like a bigger boat.
If you want a real World lesson in managing low liquidity, go play in the CEF universe for a while. Now that’s a lot of fun. 90 days to enter or exit is not unusual for me.
what does it mean that the etd traded at a discount for days? Discount relative to the NAV?
In this case how can you put in arbitrage trades?
buy the stocks sell the etf if ovepriced
sell the stock buy the etf if underpriced
but doesn’t the etf hold more than that one stock? say the etf holds 100 or so stocks…then how do you know whether there is arbitrage position or not?
Do the same analysis for all 100 stocks? The holdings and prices are known. All you’re doing is comparing the price to create 1 unit in the market vs the price that they will sell you 1 unit for. When McDouble’s and McChicken’s were on the $1 menu, there was money to be made if I tried to sell you a McGangbang for $1.75.
Sounds dirty.