ETPs (Exchange Traded Products) are securities that ride on the backs of other securities, such as stocks and bonds. They derive their value from the underlying property, and their price is altered alongside the price fluctuation of the underlying property. So if the underlying property goes up – the attached ETP goes with it. This can occur at any time, just as the value of the underlying property can change at any time. An ETP can “ride” up to several hundred properties at a time.
Why are ETPs so interesting?
ETPs have been around for a few years and started gaining popularity back in 2018. Since then their popularity has been pretty much in constant rise. So if you’re just starting to look into ETPs you should really be paying attention. The reason for the rising interest in ETPs is that they can cost significantly less than mutual funds. Being passively managed – as opposed to mutual funds for example – makes them much more cost-effective. Due to the concept of ETPs being relatively new, ETPs are viewed with a tinge of misconception and misunderstanding. One of the biggest misconceptions about ETPs has to do with their liquidity.
While ETPs can be traded in a similar fashion to their underlying securities – any day and intraday, many investors are still concerned that ETPs can’t be traded on an institutional scale. This misconception originates from investors who equate ETP trading with the trading of 1 single stock, and assume they can extrapolate the trading scale on that base. Yes, when calculating the total liquidity of an ETP you must factor in trading volumes, but don’t forget to factor in another key element of the ETP: they are open-ended funds, and can be created or redeemed daily.
In effect, the creation/redemption process provides an ETP access to the liquid properties which are held by the underlying market as well as the liquidity which stems from the ETP’s daily trading volume.
ETP liquidity and the ETP market
Notably, there are 2 markets driving ETP liquidity: the primary and the secondary market. So let’s see how this structure works, starting rather – with the secondary market.
The secondary market is a collection of ETP shares which are in motion: transferring from those investors who sell them to those who buy them. Sales are conducted by exchanges or as OTCs (Over The Counter) through brokers. An ETPs liquidity in this market is based on the trading volume in ETP shares at any given day. The secondary market enables investors to buy and sell ETP shares using mechanics similar to the ones used when trading single stocks. This market is one anyone can participate in, and most people are well-acquainted with it.
The primary market is available only to specific APs (Authorised Participants). Here the APs create or redeem ETPs to match demand: they create ETPs when there’s unanswered demand, and redeem ETPs when supply is overflowing. They perform either task at any time as supply and demand shift. The liquidity of this market is based on the liquidity of the underlying securities of each specific ETP. Subsequently to the two markets working at the same time, the liquidity of the ETP can be calculated by adding the liquidity of the underlying market to secondary market supply and demand.
The creation and redemption process in which APs conduct in the primary market provides an appropriate supply of ETP shares for changing demand levels whilst not affecting other fund investors. New ETP shares can be created to match rising demand in exchange for underlying properties. The same thing works in the opposite direction – when demand drops and supply of ETPs overflows, they can be exchanged into underlying assets by an AP. The decision to create or redeem is in the hands of the APs alone, and the investor can not take part in the process. This mechanism helps moderate the market.
To better understand this mechanism, we need to look at an example. Let’s examine a simplified life cycle of a trade.
An investor decides to buy 500,000 ETP shares.
The investor places an order with a broker.
The broker checks available shares in the secondary market and sees there are only 200,000 available to him.
The broker is also an AP, and so is able to initiate a creation of shares.
The broker buys a basket of securities held by the ETP
The securities are sent to the ETP issuer to order to exchange them for the remaining 300,000 shares
The broker completes the transaction by delivering 500,000 ETP shares to the investor.
If we want to know the liquidity of an ETP, it is imperative we achieve a firm grasp on the liquidity of its underlying shares. As previously mentioned – the underlying shares are a significant part of the equation. A commonly used method to learn the liquidity of the underlying assets is to conduct a pre-trade analysis and examine the potential market impact of your chosen transaction size. This method can be very useful but demanding. There are other methods – some less rigorous than this one, but the main takeaway is that this is a necessary process to undergo when trading ETPs.
What’s new in ETPs
As 2019 wound to a close, financial data provider Broadridge Financial Solutions surveyed 513 financial advisors in the US, with over 10$ million in managed assets and a minimum of 10% invested in ETFs. Out of those surveyed, 83% said they enhanced their ETF allocation over the past 2 years. 73% of respondents plan to increase their ETF allocation even more in 2020.
ETFs (Exchange Traded Funds) are similar to mutual funds and are one of the products under the ETP umbrella. Effectively they are a type of ETP. Unlike a mutual fund, they are passively managed, and so cost less to manage.
The main reason stated for this allocation growth (according to 49% of survey participants) was the savings in management cost. 17% of respondents claimed tax efficiency was the reason for this growth and 13% cited diversification.
Growth is not always good. This increase in ETF allocations brings a reduction in mutual fund allocations, and of course reduces the need for mutual fund managers, with many of the survey respondents citing the shift of assets from the mutual funds to the ETF as the plan for 2020.
One interesting thing the survey also found was the variations of ETF usage among financial advisors. So while an overwhelming majority of advisors have been and are shifting assets to ETFs, the way ETFs are being used by advisors can vary greatly, and so can the way advisors make decisions for their clients. According to Matthew Schiffman, Principal for Distribution Insight at Broadridge, “There are clear opportunities for managers to establish mindshare around new products, including non-transparent active ETFs and thematic ETFs.”
Chief Analyst at EverFx