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Last summer, a trading glitch at exchange-traded fund (ETF) market maker Knight Capital resulted in a dizzying 30-minute roller-coaster ride on the New York Stock Exchange as orders suddenly and inexplicably flooded in for some 150 stocks. Spreads ballooned for a handful of less-liquid ETFs as investors scratched their heads over what was going on. The event put Knight Capital in the spotlight, but, more important, it shed light on the crucial role that authorized participants play in the day-to-day trading of ETFs.

The key message: it’s important to look under the hood and understand the trading dynamics behind ETFs. Indeed, pension funds are using ETFs in greater numbers, mainly as a way to manage cash during manager transitions and to add liquidity to an existing asset allocation (i.e., emerging markets or global equities).

When liquidity is king, plan sponsors must understand how ETF trading dynamics within an ETF work. ETF trading dynamics can have a big impact on costs, according to a research paper released in October by the Investment Trading Group (ITG). The research looks at 12 popular ETFs and reveals that all of them exhibit different characteristics when it comes to liquidity and costs. It all boils down to the limit order book.

The limit order book for ETFs is deeper than that for common stocks with similar daily share volume, price, spread and volatility characteristics, especially at price levels immediately surrounding the prevailing mid-quotes.

For investors, it means the costs of instantaneous execution (“climbing up the book”) are significantly lower for ETFs than for the matched common stocks. All good so far…except that for investors like pension funds, which are focused on liquidity, the paper also finds that limit order books of ETFs can be highly volatile, with the number of ETF units that can be raised by climbing the limit order book changing dramatically at different points in a single trading day. However, every ETF has an optimal point in the day when liquidity will be at its peak and when transaction costs will be at their lowest. Therefore, say the authors of the paper, investors must understand how an ETF’s shares are created and redeemed to be able to understand how it achieves that crucial balance between liquidity and cost.

The key message here: when liquidity is paramount, you’d better understand the trading dynamics behind what you buy. Otherwise, when you need to make a quick exit, you might end up paying more than you thought.

Caroline Cakebread is editor of Canadian Investment Review and based in Toronto.
© Copyright 2014 Rogers Publishing Ltd. Originally published on benefitscanada.com

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