ETF Capital Markets Desk: Trading, Arbitrage and the New ETF

    David Mann

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

    Investors who purchase exchange-traded funds (ETFs) expect the price of an ETF to be in line with the value of its underlying basket of securities. ETF arbitrage is the process that keeps those two values in line. To conclude this series on ETF arbitrage. David Mann, our head of Capital Markets, Global Exchange-Traded Funds, discusses what could cause an ETF to trade outside its usual arbitrage bands.

    As we discussed in our previous post, there are three main groups of ETF market participants trading on a given day:  ETF investors (Group 1) ETF market makers (Group 2), and high-frequency stock traders (Group 3). Each of these groups will have varying interest in an ETF based on its asset class, intraday trading and volume, among other characteristics. We can use the growth of an ETF to highlight how these groups interact.

    An ETF is Born

    With a new ETF, there may be only one—or very few—parties available to sell shares. These “Seeding Participants” are often ETF market makers who hold the initial inventory in a fund. These Seeding Participants are eager for a product to succeed, as they would prefer not to keep the inventory on their books.

    Investors who want to purchase shares of the new ETF (remember we have no shareholders yet!) will buy them from the ETF market maker. The price of the ETF will generally be around the ETF creation band, which represents the costs to the ETF market maker of buying and selling the underlying basket of securities.

    ETF investors transacting with ETF market makers represent the majority of trading during this phase of the ETF lifecycle.

    An ETF grows

    This process continues as more investors are interested in the new ETF. The volumes start increasing, and the size of our hypothetical ETF starts growing as new shares are created to meet that investor demand. From the ETF market maker’s perspective, nothing has changed as they are still selling ETF shares at a price based on what the ETF basket is worth and then creating new ETF shares to satisfy the demand. The trading will still occur around the ETF creation band.

    Eventually, some of the early buyers of our new ETF will want to sell their position. This introduces a new dynamic where existing shareholders are trading with new investors.

    The amount of existing shareholders transacting with new investors will dictate how involved the ETF market makers need to be on a given day as the buying/selling pressure will push the price of the ETF towards its redemption or creation arbitrage band. Note, the trading can now start occurring within the ETF arbitrage bands.

    The majority of trading is still primarily from Group 1 and Group 2, although now there is more activity with Group 1 trading amongst themselves. Group 3 is still on the sideline, waiting for the volume to increase even further.

    An ETF Matures

    Eventually our hypothetical ETF starts trading hundreds of thousands of shares each day, and the assets grow into the billions. High-frequency stock traders are likely to get involved at this stage as they can now buy and sell enough shares each day to fit their model. Since market demand is the driver of their model, these traders will push the price higher or lower based on the market sentiment that day.  Note, all three groups are now active in this ETF, and the trading can occur anywhere, even outside the arbitrage bands.

    The Potential Cost of Liquidity

    Let’s spend a little more time on this last stage of the trading and price discovery process. On the surface, large amounts of volume sound great as optically, the bid/ask spreads will be very tight.

    However, the liquidity can come at a potential cost, which is the eventual participation of the aforementioned high-frequency traders. As that group’s percentage of the daily volume increases, the ETF starts to trade more like a stock as opposed to a fund that has an underlying value.

    That means that on days where there is either positive or negative sentiment (which I would argue, is most of the time), the ETF could very easily trade outside of its arbitrage bands. This potential liquidity cost is an ongoing conversation we have with investors every day.

    Wrapping up

    This concludes our four-part discussion on ETF arbitrage bands, which hopefully gave you some new things to think about regarding the intraday trading of ETFs. You should now have a better understanding of the relationship between the ETF and its basket, and how that relationship is far more meaningful and relevant than simply looking at an ETF’s volume or bid/ask spread.

    Better analysis will lead to a better experience using ETFs.

    Until the next time!

    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. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.