ETF Capital Markets Desk: Amount of Shares on the Bid/Offer

    David Mann

    David MannHead of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments

    In our last blog, David Mann, head of Capital Markets, Global ETFs, addressed the subject of spreads, and why he thinks some common investor beliefs about the value of tight spreads may be worth further examination when it comes to investing in exchange-traded funds (ETFs). Here, he dives deeper into spreads, addressing some misconceptions about size of the bid/ask price.

    Today, I am going to talk a little bit about the amount of shares available on the bid or offer (also called ask) and the ideas many prospective investors in exchange-traded funds (ETFs) seem to have about the matter.

    Investors typically like to see a large number of shares available on the offer, ideally an amount greater than the size they are looking to purchase. When this is not the case, the misconception is that the order would either be difficult to execute or would move the market. This becomes a liquidity matter, which we have discussed in a previous post.

    Just to be clear, let me reiterate the ETF liquidity takeaway from my perspective: investors can often purchase multiple times the amount of stock available on the offer because of a market participant’s ability to access the liquidity of the underlying basket.

    So hopefully we are now comfortable with the idea that even if there are only 1,000 shares on the offer, it is possible that 100,000 shares could trade at that same price. But that does lead us to an interesting question: if market participants are willing to sell 100,000 shares at a specific price, why only offer 1,000 shares?

    The answer comes down to risk in a couple forms.

    For larger investors, the first amount of risk to consider is at a firm-wide capital level. Currently there are over 1,900 ETFs listed in the United States. If an ETF market-making firm decided to offer 100,000 shares in only 10% of those names (in my experience, it would most likely be active in far more than this), it would be risking almost $1 billion of capital. That is a significant amount of capital to risk at one time, especially given there have been several instances of extreme market volatility in recent years.

    The second risk is at the individual product level. These firms are very good at calculating the price of an ETF based on its basket of underlying securities. However, on rare occasions they can make mistakes during these calculations. For larger ETFs with high average volumes, there are usually multiple firms providing markets which serves as a real-time check on their calculated price. For newer products where there is often only one market maker, that check is often not available.

    So now we can see the infamous “chicken-or-the-egg” ETF argument. A client may be interested in a new ETF but wants to see a lot of shares available on the offer before trading. Generally, market participants—the market makers responsible for continuously quoting new products—do not want to offer a lot of shares until there are clients interested in buying an ETF. Sadly, often new products do not get traction because neither side is willing to move first.

    I would make two observations regarding that dilemma. The first is to reiterate the liquidity point I made in an earlier blog. Especially with new products, it is very possible that more volume can be transacted on the offer than what is currently shown in the market.

    The second is that the firms who make markets in ETFs want products to succeed as much as the sponsors do. If investors are interested, ETF market makers will generally be there to provide liquidity in even the newest of ETFs at prices in line with those of the underlying securities.

    David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
    This information is intended for US residents only.

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    What Are the Risks?

    All investments involve risks, including possible loss of principal. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect deduction of any fees or expenses. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns.