It is no secret that ETPs continue their dominant growth in popularity, as global ETP/ETF AUM reached a new high of $6 trillion in 2019
1. The combination of enhanced transparency, lower costs and increased liquidity has made them the preferred alternative to traditional mutual funds. Despite the increased awareness of these products, some general misconceptions still persist – especially regarding the topic of liquidity.
When most investors check data on liquidity, the steps are relatively straightforward. Check the bid price, the ask price, and the volume being traded. The smaller the spread and the higher the volume, the more liquid the product is. Simple, right? Yes – and no. In the case of a normal stock, the aforementioned is true. However, when considering the same for exchange-traded products (which include ETFs), the indicator has another layer to it.
Prior to exploring the depths of ETP liquidity, let us review a few key terms distinctive to these products:
• Authorized participant (AP) – Usually a large financial institution, like an investment bank that
interacts directly with the ETP issuer.
• Market maker (MM) – Financial institution that has a contract with the exchange to provide
constant bid/offer spreads throughout the day. In many cases, the AP is also the MM.
Unlike typical mutual funds and closed-end funds, ETPs have an inherent redemption mechanism, which helps keep the market price in line with its NAV. Like normal stocks, as the ETP price fluctuates throughout the trading day, the AP can step in and do one of the following:
a. If the market price > NAV, the AP can buy the constituent stocks and simultaneously
exchange them for ETP shares, which can then be sold to investors.
b. In the opposite scenario, where NAV > market price, the AP can purchase ETP securities and
exchange them for the constituent securities, which it will then sell on the market to make a riskless profit.
