ETF sponsors will tell you that the three biggest issues in the industry are education, education and education, especially in relation to the RIA channel.

There are countless numbers of websites, white papers, webinars, even bloggers and columnists that dissect the ETF structure and all of its usefulness. But if you’re looking to move your client’s assets out of mutual funds and into ETFs, there is not much independent information to guide you.

There are currently $1.3 trillion in ETFs and close to $12 trillion in mutual funds. As passive investing becomes a larger portion of portfolio construction, The coming years could see three, four or even five trillion dollars move out of Mutual Funds and into ETFs. The process to move that amount of capital creates opportunities, challenges and the need for more education.

Let’s look at a few of the key components and risks in trading large blocks of ETF shares.

Capital Markets Desks

ETF providers have created special groups in their organizations to help educate clients in the trade execution process. These capital market desks can be a source of good information, but they are not actually broker-dealers. It is therefore imperative that an advisor remains completely involved in the trade, understands all the various decision points and is familiar with the participants in the trade in order to secure that the client gets a quality execution. 

Sourcing Liquidity (creation vs. open market)

One unique attribute of ETFs is the creation/redemption process.  Approved Participants  (APs) are trading desks the ETF issuer has given the right to transact directly with the custodial bank to create or redeem ETF shares. Creating shares outside of the fund leads ETFs to be tax efficient but also creates some complexity in the trading of large blocks of ETF shares. 

The first decision necessary is whether to create shares directly through the custodial bank via an AP or have your AP buy them in the open market.  This decision should be based on the size of the trade and the potential market impact of the trade.

Size of the Trade

The size of the trade should be measured in relation to the average daily volume (ADV) of the ETF and the liquidity of the underlying securities of the ETF.

The assets (AUM) of a fund is not an indicator of liquidity.  A large block trade is usually in excess of 50 % the ADV (a 5-day average of the ADV is generally used) and can take more than a day to fully execute. 

It should be noted that the nature of the underlying assets of the fund is a key component; equity underlying versus fixed income or commodity-based can alter the decision to create shares or enter the open market.

Lending Tree Approach

The trading of ETFs has evolved and moved like any market towards a state of efficiency. The more liquid ETFs, such as SPY and QQQ, can be traded very effectively through almost any desk.

In the less liquid names, however, there are occasions when another option may be considered. Certain intermediaries in the marketplace today serve as aggregators. These intermediaries client orders and shop them to the various APs, aggregating OTC quotes from these firms and seeking best price on behalf of their clients for a fee.

As one ETF veteran explained, it is the same methodology as Lending Tree; type in a request and out comes a series of quotes based on a competitive bid/offer environment. This can be a cost-effective and efficient process for smaller block trades in ETFs but it is not without risks. Information leakage about your trade can seep into the market and move the price away from the funds fair value.

Bulge bracket ETF specialists should be used when executing large block trades. They are the core ecosystem of ETFs; they make markets, commit capital and own risks books in ETFs.  Their role in the trade is to reduce the market impact of your order by using their capital, avoid information leakage and produce an execution that is in equilibrium with the fair value of the ETF.

Conclusion

Trading ETF shares in large quantities is not directly analogous with trading single stocks. Supply/demand is part of the equation, but the creation/redemption mechanism inherent in ETFs adds an additional layer of complexity—and potential for better outcomes—to the trade. Consider the trade-offs carefully before establishing your broker relationships—or review them if you already have relationships in place—to ensure your clients’ trades are getting executed as close to fair value as possible.