ETF Liquidity Explained

1. ETF Liquidity Explained Bradley Kay Associate Director, European ETF Research Ben Johnson ETF Strategist September 29, 2010

2. Agenda What is liquidity? How the ETF marketplace works Why the biggest ETFs keep gathering more assets Rules of thumb for ETF execution Outlook for the future 2

3. What Is Liquidity? The ability to buy and sell a security without moving the price Factors contributing to greater liquidity Lots of existing shareholders leads to natural buyers and sellers General agreement on the value of the security Ready supply of capital for market makers 3

4. Liquidity in ETFs Liquidity in European ETFs currently comes almost entirely from market makers who create or redeem shares at the end of day Requires a slight spread between buy and sell prices, to compensate market makers for the costs of hedging Market makers are paid to keep spreads at a pre-specified level (typically below 1% or 2% for some less-liquid funds) Since the market maker has to hedge, the liquidity of ETF portfolio holdings and ease of borrowing capital matter The largest ETFs move toward liquidity coming from existing shareholders Allows for the lowest transaction costs, since buyers and sellers are happy to receive fair value 4 4

5. How an ETF Works ETF Creation/Redemption Process ETF Provider Securities (In-kind transfer) ETF Shares Primary Market Market Maker Secondary Market ETF Shares Buyer Seller Stock Exchange

6. How a Traditional Fund Works Graphic Source: Blackrock

7. Liquidity in Traditional Funds versus ETFs Traditional funds still need to tap the capital markets each day in order to buy and sell portfolio holdings Not immune from the transaction costs incurred by market makers crucial to ETF trading Some ability to avoid transaction costs by netting inflows against outflows ETFs force the purchaser or seller to bear the cost of their trade, while traditional funds spread it among all existing shareholders Makes the cost of liquidity explicit Provides the ETF shareholder with a measure of control over their transaction costs 7 7

8. Why This All Matters Intra-day liquidity allows you to see the price where you are buying and selling, rather than waiting for the end of day Allows you to rebalance a portfolio immediately, rather than waiting a day or two to get out of one fund and into another The creation and redemption process, and the secondary market on the stock exchange that allows it, is the key to ETFs’ low costs Only interacting with a handful of major market makers keeps accounting costs minimal Pushes trading to arbitrageurs and trading firms who can do it for the lowest cost, since they make the market at the margin 8 8

9. Does It Work? The arbitrage process keeps market prices for the ETF extremely close to fair value, even as assets change rapidly If the underlying securities in an ETF are liquid, then the ETF will be as well under the majority of market circumstances Unlike stocks, new ETF shares can be created, so prices do not get driven up substantially by asset inflows Example: a new US ETF from entrant Schwab Intended for retail investors, so inflows came from many sources Invests in large-cap US stocks, a very liquid underlying market Assets grew 100-fold, from $2 million to $237 million, in only six months 9 9

10. Does It Work? Source: Morningstar Direct 10 10

11. Liquidity Over Time Liquidity within all securities markets can vary drastically over time Most visible in ETFs, since their bid/ask spreads make the costs of trading explicit During market crises, spreads will generally widen as market makers lose access to hedging capital and investors become less certain about fair values The largest ETFs in the US kept a steady market through the 2008-2009 crisis, sometimes providing far more liquidity than their underlying securities 11 11

12. Dangers of Illiquidity Typically not much of a problem to buy into a less-liquid ETF May require more patience if it is not monitored actively by market makers May require going directly to a market maker The loss of liquidity during a crisis tends to be steepest for smaller and less liquid ETFs within a category, as these are most reliant on market makers keeping an orderly market Not saved in a traditional fund, as they still need to sell securities in the vanishing market to meet share redemptions Costs spread among all existing shareholders 12 12

13. How to Measure Liquidity • Simple approximations for liquidity • More assets =more potential buyers and sellers • Greater daily volume = more flow, lower margins demanded • Liquid underlying = easy hedging for market makers • More precise measures of liquidity • Bid/ask spread • Depth of order book (XLM) • Premium/discount • Market impact from past trades

14. Bid / Ask Spreads A large component of buying and selling costs for ETFs is the difference between the bid and the ask Larger ETFs typically have tighter bid/ask spreads Data as of August 30th, 2010 14

15. Bid / Ask Spreads Liquidity costs are a crucial consideration when comparing ETFs tracking similar or identical indices 15

16. Premiums and Discounts • Smaller fluctuations in the past = more liquidity 16

17. Rules of Thumb for Trading Use limit orders rather than market orders Does not rely on a deep order book Allows you to set a fair price for the purchase or sale Market makers can see your order on the exchange and fill it Stop-loss orders tend to cause the biggest problems Drops a market order on the exchange when prices are going down Tends to place a sell order precisely when liquidity is lowest Led to major losses in the May 6 “Flash Crash” in the US Circuit breakers on European exchanges will keep losses smaller, but not prevent them entirely 17

18. ETF Trade Execution Gone Wrong ETF with nearly $1 billion in assets under management Relatively strong liquidity in the secondary market 18

19. ETF Trade Execution Gone Wrong Too large of a market order for the immediate liquidity on the exchange Market makers do not always want to post their full order size on funds that they are not constantly monitoring This order executed at a variety of prices, with the peak being 19% above fair value After the market order went through the books, the bid immediately came back down to near the fair value of the ETF Could have been avoided by using a limit order Look at iNAV to see what fair value of the portfolio is Bid, ask, and recent trade prices also give a good idea of the current fair value 19

20. Fair Value Pricing The iNAV is not always accurate Foreign stock ETFs trade in Europe even when the underlying markets are closed Events can arise when local markets are closed that will impact valuation once trading opens, but iNAV may not incorporate that change in value Market makers rely on futures, local listings of foreign shares, demand changes, and proprietary algorithms to determine a security’s “fair value” If a large number of trades are occurring at fairly tight spreads, that suggests a reasonable market price even if it differs from iNAV Graphic Source: Vanguard 20

21. Trading Best Practices Use limit orders Avoid stop-loss orders Evaluate the market Indicative values Recent trade prices Bid / ask quotes Avoid trading during extreme volatility (Flash Crash) Trade when the underlying market is open and functioning 21

22. The Future for European ETF Liquidity Most investors are still large, slow-trading institutions Even the highest volume ETF in Europe only trades about £50 million per day through the exchange, less than 1/250th of the volume traded through SPDRs (the world’s largest and most liquid ETF) The market is still reliant on market makers and could face some trading disruptions in another major crash Liquidity is growing rapidly Hedge funds are shifting toward using ETFs in place of OTC derivatives from investment banks Retail investors and advisers are starting to buy off LSE, Deutsche Börse, and Borsa Italiana 22 22

23. ETF Liquidity is Growing Rapidly • Year-to-date trends through August are encouraging • Though the trend is positive, there is still a long way to go 23 23

24. The Future for European ETF Liquidity ETFs pulling in the greatest amount of assets and putting up the largest volumes will continue to succeed Lower trading costs mean a lower total cost of ownership More purchasing across the European exchanges A spread that’s only one penny tighter on a £10 share is worth £100 on a £10,000 trade Biggest ETFs will keep their liquidity even during a crash Likely to end up as one of the lowest-cost ways to trade illiquid asset classes like fixed-income and foreign markets during a crisis 24 24

25. 25