In essence the primary market is where ETF shares are created and redeemed and then they are publicly traded in secondary markets, helping to ensure liquidity as well as ensuring orderly and efficient trading.
We will have a look at the secondary market first, which is where investors and their advisers will encounter ETFs.
Advisers are used to dealing directly with fund managers or platforms when they invest their clients’ money. But for those that have taken the plunge, buying ETF shares has required a bit of a cultural shift, starting with thinking about how the secondary market works, including understanding pricing, spreads and liquidity.
Buyers and sellers of ETF shares trading on the stock exchange comprise the secondary market. Financial advisers can trade ETFs on behalf of their clients through stockbrokers or platforms, some of which simply execute trades on behalf of the adviser, while some can also offer advice and guidance to advisers and their investors.
Market makers provide continuously updated on-screen buy (‘offer’) and sell (‘bid’) quotes at which they are willing to deal in ETFs throughout the trading day. They also provide liquidity for buy and sell orders in the secondary market for the ETF.
The difference between the bid and the offer price is known as the bid-offer spread. Under stock exchange rules, market makers are obliged to ensure that the spread remains below a certain percentage of the price. The availability of real-time quotes means advisers have the option to deal at a known price, instead of an unknown future price, as with many traditional mutual funds.
A number of factors influence the market price for an ETF, including the share price movement of the underlying securities, exchange rate movements for international funds and investor demand for the ETF. Issuers calculate and publish the closing net asset value of the ETF daily. They base the net asset value on the closing market prices of the securities in the underlying portfolio after fees and expenses. Although ETFs can trade above or below the intraday NAV of the underlying index at a given point during the day, underlying market forces generally keep ETFs trading near their intraday NAV.
Brokers and platform usually provide their clients with up-to-the-minute ETF prices using subscription data terminals. You can also find delayed intraday prices for free from the stock exchange or on many online services by searching for the ETF’s name or alphanumeric stock market ‘ticker’. You can find the ETF ticker on the ETF factsheet, which normally appears on the issuer’s website. You can also monitor ETF share daily closing prices on the issuer’s website, which should provide a daily closing price and the closing NAV.
Narrow spreads and liquid markets are more attractive to investors, increasing the demand for securities which, in turn, creates higher trading volumes. Market makers earn their revenue from trading and have a strong motivation to maintain tight ETF bid-offer spreads. If spreads widen too far it stifles demand and may result in lower volumes of business for the market maker. However ETF spreads can widen during periods of market uncertainty, just as they do with company shares traded on the stock exchange.
Advisers interact with ETFs only in the secondary market but behind the scenes, in the ‘primary market’, different market participants work to ensure liquidity by creating or redeeming shares, as well as ensuring orderly and efficient trading. We have touched on market makers, so the other key players to consider are ‘authorised participants’, usually large financial institutions with direct access to the stock exchange. They have an agreement in place with the ETF issuer (the fund manager) that allows them to create and redeem ETF shares directly with the issuer of the fund.
An authorised participant applies to the issuer for whole creation units, typically 100,000 ETF shares or more. They can create ETF shares by delivering a physical collection of securities, referred to as a ‘basket’, or cash that equals the value of one unit (called an ‘in-specie’ or ‘in-kind’ transfer). In exchange, the authorised participant will receive a ‘creation unit’ of equal value; the ETF shares that made up the creation unit can then be sold to the market or held by the authorised participant. The ‘basket’ of securities is published each day and reflects the necessary value of cash or securities (with securities in weightings that closely replicate the value and profile of the index) that will need to be delivered by an authorised participant in exchange for ETF creation units. Units are redeemed by returning the ‘creation unit’ to the ETF issuer, in exchange for cash or securities. By creating and redeeming shares directly with the issuer in large blocks (in the primary market), authorised participants can provide liquidity to the market generally and also to large institutional investors who want to execute larger ETF trades. Some authorised participants are market makers, but not all.
Authorised participants calculate the value of the ETF securities continuously throughout the trading day. If the price of the ETF moves too far from the value of the underlying securities, they can use their creation/redemption facility to profit from it. When they do this they affect the price and it will tighten closer to NAV. This helps give investors confidence that the quoted market prices for an ETF closely match the value of the underlying portfolio and index that the ETF represents.
The primary market controls the number of ETF shares available to the market. This provides full liquidity in the secondary market because the issuer can create or redeem ETF securities to meet market demand. As demand for an ETF grows, more units can be created, thus increasing the fund’s assets under management like other open-ended investment funds.
For example, if a large investor wanted to buy a block of ETF shares that exceeded available liquidity in the secondary market, they could contact an authorised participant to arrange the creation of the required shares with the issuer. Conversely, if they wanted to sell a large block of ETF shares, the authorised participant would provide a purchase price for the securities with the investor and redeem ETF shares with the issuer.
As we have seen, although there are some unique moving parts to the ETF story for advisers to get their heads around, their growing global popularity among advisers rests on trading flexibility, price availability and low cost. Advisers are coming to realise that index ETFs are just another way to index. With the end of commission and the opportunity to consider ETFs as part of the whole of market, the growth in ETF adoption will no doubt continue.
Nick Blake is head of retail of Vanguard Asset Management
Key Points
In essence the primary market is where ETF shares are created and redeemed and then they are publicly traded in secondary markets.
Narrow spreads and liquid markets are more attractive to investors, increasing the demand for securities which, in turn, creates higher trading volumes.
The primary market controls the number of ETF shares available to the market.
