By Dan Hallett on April 3, 2024
Many investors and advisors are reluctant to buy an Exchange Traded Fund (ETF) with a relatively small asset base or low trading volume. This results from the fear of inputting a trade so large that it causes an unfavourable move in the market price (i.e., pushing the price up before a buy order is filled – or down for sell orders); or having trades not filled at all.
We executed large trades in an ETF over the past couple of years at little cost and without moving the market price. Before explaining how, let’s start with some ETF liquidity basics.
ETF Liquidity
Liquidity refers to the ease of buying or selling. Most ETFs invest in stocks or bonds that are easily traded in larger quantities. The relative few that hold less-liquid investments take longer to trade and involve more costs. ETF trading volume – the quantity of ETF units traded daily – is one sign of liquidity, but it’s not the most important factor.
When investors want to buy more ETF units than sellers are offering to sell, ETF sponsors work with institutional traders (“market makers”) to create more units to meet buyers’ demand – i.e., “creation”. Similarly, when investors want to sell their ETF units but there are too few buyers, sponsors and market makers absorb that excess supply of units – i.e., “redemption”.
(For a simple and creative explanation of creation and redemption, I highly recommend this iShares video: The story of creation and redemption.)
A tiny but highly-liquid ETF
The BMO Global Equity Fund Active ETF (BGEQ) is an ETF listed on the NEO Exchange that invests in shares of about seventy large global companies. Over the past few months, only about two hundred units traded daily – equal to about $4,200 per day.
While it has just over $2 million of net assets, a large investor could, for example, easily invest tens of millions of dollars in this ETF because most of its holdings – e.g., NVIDIA, Microsoft, Eli Lilly – boast billions of dollars of daily trading volume. It is the liquidity of those stocks that defines the ETF’s liquidity because of the aforementioned creation and redemption mechanism.
Our ETF search
In early 2022, we liquidated our clients’ positions in an investment fund; with the proceeds destined for a new fund that was not yet set up. We searched for an ETF to maintain market exposure until the new fund launched.
Our search landed on an ETF with just $6 million in net assets and thin trading volume. Since our planned investment was $60 million, we examined the ETF’s underlying stocks – which included many smaller global companies. We concluded that there was plenty of liquidity for our trades – which the ETF’s sponsor validated.
Why contact the sponsor? Their interests are aligned with our clients. Neither of us wants trading activity that disrupts the ETF’s price or causes it to deviate significantly from its underlying net asset value (NAV). Accordingly, their confirmation added comfort.
Trade Execution
As a discretionary portfolio manager, we execute bulk trades. We model trade amounts for each client account with our portfolio management software. We then execute one big (“bulk”) trade for the aggregate number of units. After the trade settles, our system allocates each client’s share of the bulk trade to their individual accounts.
There are two choices for such large trades. An intraday trade in the open market is how most trades are executed. In this case, our broker gets price quotes from all key market makers. Once we approve the price, our broker executes the trade for all clients. The other option is a “NAV trade”, which occurs after market close precisely at the ETF’s net asset value (NAV) per unit, much like a mutual fund.
Since market makers generate profits from spread (i.e., selling securities at slightly higher prices than purchase prices), a NAV trade (which involves no spread) requires the addition of a profit margin for the market maker. Depending on the ETF price, the market maker’s margin might be $0.003 to $0.02 per unit added to our purchase price of each ETF unit.
We went with a NAV trade in this case, deploying $60 million into a $6 million ETF very efficiently in a single trade. When it was time to move out of this ETF, it boasted more than $90 million in net assets. We followed the identical process to sell our stake (then about two-thirds of the fund’s assets) in one big, efficient NAV trade.
Reflections
Our securities registration as a Portfolio Manager, the authority that clients grant us to trade on their behalf, and our portfolio management software allow us to bulk trade as described above. This is more efficient than having to trade for each client separately – in terms of commissions paid, execution price, and fairness (every client gets the same price). And it’s all completed in a single trade.
While we were not a long-term investor in this ETF, the sponsor is still happy since the ETF now has about triple the assets it had when we made our initial investment. While NAV trades are not an option for most individual investors, rest assured that brokers and market makers work well together to execute the vast majority of ETF trades fairly and efficiently.
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