Written by: ProShares
ETFs offer attractive features—access to a broad range of asset classes, sectors and styles in a liquid, transparent and cost-effective vehicle. But before using that vehicle, it’s helpful to understand how it works, especially the sources of ETF liquidity and the mechanics of trading them. Understanding these points may help you improve execution when buying and selling ETFs.
The Primary Market—Creation/Redemption of ETF Shares
Most investors trade ETFs on stock exchanges in the secondary market. But the actual creation and redemption of ETF shares occur in the primary market, between the ETF and authorized participants (APs) 1 —the only parties who transact directly with the ETF. The APs’ ability to continuously create and redeem shares allows them to meet the supply and demand needs of investors, making them key liquidity providers in the secondary market.
Creation. This is how APs introduce new ETF shares to the secondary market.
Redemption. This follows the same process in reverse.
The Secondary Market—Costs and Mechanics of Trading ETF Shares
Costs of Trading. In the secondary market, firms that specialize in buying and selling ETF shares—APs or market makers 2 (liquidity providers)—trade them to provide market liquidity and make a profit. This profit margin is embedded in the bid/ask spread, which reflects the implicit costs of trading ETFs.
Bid/ask spread is the difference between the bid—the highest price at which a buyer is willing to buy shares—and the ask—the lowest price at which a seller is willing to sell ETF shares. Three key factors impact the bid/ask spread:
ETF bid/ask spread = Creation/redemption fees + spread of underlying securities + risk
Executing Large Orders—Tapping Into Deeper Pools of Liquidity
There are two common ways to execute larger trades directly with liquidity providers, both allowing investors to access deeper pools of liquidity than those offered in the quoted secondary market alone:
Mechanics of Trading. To fully consider an ETF’s total costs, it is important to understand the dynamics of trading. In general, two types of orders are commonly used to trade ETF shares:
While a large number of transactions are executed using limit or market orders, investors often find their order is larger than the quoted market. There may be “hidden” liquidity within the quote that can be accessed in the market using limit or market orders. However, in some cases, it may make sense to execute trades directly through a liquidity provider. How and when to place an ETF order can depend on many factors, including price sensitivity, level of urgency and overall goals for the portfolio. Determining what factors matter most can help determine the best execution strategy.
Questions? Our capital markets experts can help. Learn more about our ETFs here .1An AP is a U.S. registered, self-clearing broker/dealer who signs an agreement with an ETF provider or distributor to become an authorized participant of a fund.
2A market maker is a broker/dealer that buys and sells securities (or ETFs) from its own inventory to facilitate trading in those securities. Most APs are market makers, but not all market makers are APs.
3IOPV is the Indicative Optimized Portfolio Value—the intraday net asset value of the basket of underlying securities
Investing involves risk, including the possible loss of principal. ProShares are non-diversified and each entails certain risks, which may include risk associated with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. Please see their summary and full prospectuses for a more complete description of risks. Carefully consider the investment objectives, risks, charges and expenses before investing. This and other information can be found in the prospectus; read carefully before investing; obtain at ProShares.com. There is no guarantee any ProShares ETF will achieve its investment objective.