The key characteristics of ETF trading

With more than 5,000 ETFs listed around the world, it can be overwhelming for a trader to know the best way to execute an ETF. In the United States, there are more than 1,600 listed, with the liquidity concentrated in the top 50 ETFs.

In addition, recent Tradebook studies on ETF trading, indicate that trading ETFs can be far different from executing regular stocks. A large stock order can have a significant splash in the market. Whereas a similarly sized large ETF order, will have less of an impact on the market. This suggests different strategies are required for executing ETFs, and generic stock algorithms will not suffice.

Additional Tradebook studies also indicate that block trading should be considered for an optimal ETF execution result.

Beyond the benefits of trading ETFs on stock exchanges, the key to successful ETF trading is understanding the key characteristics of an ETF that can guide the trader on the liquidity and prices that can be expected.

1. Creation Unit
The first attribute is the Creation Unit of an ETF. The Creation Unit is the Block Size of an ETF that can be created or redeemed with the Issuer. Typically 50,000 to 100,000 shares of the ETF, the Creation Unit is like a “Round Lot” for an ETF. Traders know that in many markets, a different price can be expected for “Round Lots” and “Odd Lots”. Usually, an “Odd Lot” will get an inferior price to trading a “Round Lot”.

For example, a trader has a 50,000 share ETF order, and the Creation Unit is also 50,000 shares. Relative to the current market quotes, a trader can expect to see a better price from the liquidity providers for 1 block trade of 50,000 ETFs. Slicing up the 50,000 share order into 5 slices of 10,000 share odd lots, may not realize the best prices.

2. INAV
The Indicative Net Asset Value, the INAV, is the intra-day net asset value of the underlying basket, translated into the ETF price. This INAV is defined by the ETF issuer, and published by the exchanges every 15 seconds, based on the last prices of the underlying securities.

This “Fair Value” gives a trader “pricing guidance” on where the trader can expect to trade an ETF. More often than not, an ETF can trade at a premium or discount to the INAV. Part of this discrepancy can be due to the delayed nature of the INAV price feed. Some can be attributed to how the INAV is calculated.

For example, many fixed income ETF INAV’s are priced with the bid price of each underlying bond. Most bonds don’t trade electronically, and some don’t even trade. Relying on a pricing service for bonds can give an inaccurate fair value of a bond ETF. Buying an ETF would normally mean paying the offer, which would make the price a premium to the bid price calculation of the INAV.

3. Implied Liquidity
The implied liquidity provides “volume guidance on the available liquidity for an ETF. An abundance of liquidity in the underlying basket indicates how many ETF shares can potentially be traded in one day.

4. Fund Flows
Fund Flows is probably the easiest characteristic to understand. ETFs can be created or redeemed everyday. This net daily inflow or outflow for an ETF gives a good indication of market sentiment each day.

5. %Off-Exchange
ETFs trade on and off-exchange. The less liquid an ETF, the more liquidity will trade off exchange, usually in block form, with a liquidity provider on one side of the transaction. These trades are reported to the Trade Reporting Facilities, the “TRF”, in real-time.

30 to 40% of ETF volume is printed off-exchange, and cannot be accessed in the dark pools. The Tradebook ETF RFQ platform gives clients access to multiple liquidity providers who specialize in ETF block liquidity.