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Minimizing Market Impact

in Large ETF Trades

The Quest for Zero Impact
Minimizing Market Impact in Large ETF Trades
The Quest for Zero Impact
As institutions embrace ETFs as investment At the same time, hedge funds, financial planners
vehicles, short and mid-term holding vehicles, and smaller institutions have expanded their
parking, active strategy replication and instant use of ETFs, as have fast-growing market
exposure to asset classes, more and more segments such as robo-advisors and other
market participants have begun to look at model-based portfolio strategies that must be
market impact. Talk about entering trades at regularly rebalanced.
net asset value without moving the market has
moved from hypothetical conference conversation These investors are taking advantage of the
to an everyday reality for institutions. liquidity ETFs offer, even in asset classes that
are not otherwise easily traded, such as foreign
The ETF market has grown sharply in recent securities, currencies, bonds and commodities.
years, accounting for an ever-larger share Employing ETFs in these asset classes can be
of both institutional and retail assets under the quickest method of expressing a market
management. Institutional investors now perspective or investment theme, and can, by
hold more than $1 trillion in ETFs, representing itself, significantly reduce trading costs.
nearly half the $2.6 trillion total (as of 01/2017).

“Being Traded Has Eclipsed U.S. GDP,” by Eric Balchunas, Bloomberg, July 30, 2015.



Yet even so, fiduciaries across both institutional and retail sectors are increasingly focused on
further reduction in ETF execution costs, since these assets tend to be more actively traded than
traditional portfolios. Bloomberg and the New York Stock Exchange estimate that trading activity
in ETFs has tripled over the last ten years, with an average turnover of 870%, versus 200% for actively
traded stock portfolios.At an asset-weighted bid-ask spread of 0.05, Bloomberg estimates that
ETF trading generates $9 billion in market impact per year.

The potentially largest cost of a trade is market impact, the price movement of the ETF caused
by the trade. For this reason, both institutional and retail investors are seeking to reduce the cost
of market impact with an execution methodology that takes advantage of the unique and broad
liquidity characteristics of ETFs.

Multiple Sources of ETF Liquidity
In order to understand how to minimize trading As a result, there are almost always multiple
impact, it may be helpful to review how ETFs sources of liquidity for ETF investors: the liquidity
are constructed. The process begins when a of the ETF itself, as it trades on the secondary
market maker, designated as an authorized market, and the liquidity of the underlying basket
participant, assembles a basket of securities that of securities that the ETF holds. In addition,
replicates the ETF’s index or target portfolio. The other sources of liquidity may exist in the futures
authorized participant delivers these securities and derivatives markets. To execute trades
to the ETF’s custodian, who in exchange, gives that do not move the ETF’s market price very
the authorized participant a “creation unit.” much, traders must look at all sources of
The creation unit is a large unit, which can be liquidity and choose a strategy that will have
broken into ETF shares and sold on the the least possible impact.
public market.
The chart below compares bid-ask spreads in
The authorized participant can create or redeem the ETF and the underlying basket of securities
ETF shares at any time. If there is a sudden for seven widely held ETFs. As you’ll see, in all
demand for a large block of ETF shares — for seven cases, the spread in the ETF is smaller
instance, if a large institutional investor wants than that of the underlying basket of securities.
to initiate a position in the ETF — the authorized That’s consistent with the experiences small and
participant can buy the underlying securities mid-sized investors have had in the ETF market
and create new ETF shares. If, by contrast, an – that is simpler and more cost-efficient to trade
investor wants to sell a large position, the the ETF than the underlying securities.
authorized participant can break the ETF into its
underlying components and sell these securities.





Secondary 0.52bps 0.95bps 3.26bps 0.88bps 0.97bps 2.93bps 3.09bps

Basket 4.66bps 2.88bps 48.91bps 5.30bps 5.84bps 14.25bps 170.12bps

ADV 182mm 51.3mm 74.6mm 4.2mm 56.3mm 3.5mm 14.4mm

Size of Trust
$169.64bn $22.19bn $17.66bn $23.53bn $34.7bn $13.21bn $9.15bn
(in dollars)

However, very large trades, particularly in ETFs with smaller assets under management, can create
significant market impact. The key, in these cases, is to truly understand the unique nuances of
each ETF being traded, as well as the characteristics of and market for its underlying securities. As
a result, trading strategies vary by asset class, the specific ETF being traded, the underlying assets,
market conditions and other factors. Here are three examples of large ETF trades with minimal
market impact.

Trading in Global Equities
Global equities poise a multifaceted set of issues, ETF. However, the creation/redemption process
from currency, to the movement and liquidity of entails its own trading costs and tax liabilities,
underlying equities trading on multiple markets, influencing the cost of the transaction.
in multiple time zones simultaneously. A large
global money manager wanted to move $1 In this case, the solution was to use our balance
billion in assets out of two ETFs with regional sheet to execute the exchange. Traders bought
market exposure, specifically Europe and Japan, blocks of shares in the two regional ETFs, broke
into a lower cost, more liquid ETF with a global them down into their individual components and
mandate. The simplest strategy — selling around paired their risks with long and short positions in the
a half a billion each from the regional ETFs and trading desk’s proprietary portfolio of roughly
buying a billion in the global one — would 400 ETFs. Then, the trading desk worked to
have a market impact of approximately 60 basis trade out of our position while managing risk.
points, roundtrip. The transaction was executed for less than 5
basis points, saving the customer approximately
Upon further examination, the global ETF and $3 million.
the two regional ones owned many of the same
companies. About 60% of the trade would involve Our focus on limiting costs for this trade gave
simply moving the Japanese stocks held by the this customer the flexibility to reallocate a large
Japan ETF and the European stocks held by the portion of his portfolio into a lower cost, more
European ETF into the global ETF. liquid vehicle, which may reduce the cost for
monthly rebalancing in the future. If the investment
One alternative would be to use the creation/ manager had to pay the full cost for trading
redemption process to break the two regional between the three ETFs in the secondary market,
ETFs into their component stocks and then he may not have made the shift due to market
exchange those stocks, plus or minus any impact (friction). Executing the trades will benefit
differences in holdings, for shares in the global him and his investors going forward.



Exploring How to Minimize Market Impact
in Less Liquid Fixed Income ETFs
Fixed income markets are far less liquid, and spreads are wider, than the global equity market, but
market impact can still be managed by looking at multiple sources of liquidity.

For example, consider a portfolio manager who wanted to transition from one Lehman Aggregate
benchmarked ETF to another in a billion-dollar trade. To facilitate the transaction, our trader first
went to the issuer of the ETF currently held by the client and received a listing of all the bonds
held in the underlying portfolio — in other words, the basket of securities that would be exchanged
for a $1 billion redemption. The trading desk then compared this to the list provided by the issuer
of the second ETF to determine how much of that underlying portfolio would be accepted in
exchange for ETF shares. Because both ETFs are benchmarked to the same index, there was
considerable overlap.

However, there were some small and significant differences between the ETFs. For example, one
struck NAV at 4 p.m., the other at 3 p.m., leaving a one-hour difference in the valuations of the
securities underlying the portfolio.

Moreover, the first ETF owned mortgage-backed securities, representing roughly a third of the
portfolio, and these holdings are not an in-kind deliverable vehicle. So even if the second issuer
accepted the non-mortgage portion of the basket, there is, at best, only 65% cross-ownership.

The cost of the transition — including transaction costs at both ETFs, managing the risks inherent
in the different NAV strike and the mortgage backed securities ended up at roughly 8 to 9 basis
points. The client ultimately decided that she couldn’t justify a trade between two very similar
ETFs at 9 basis points; she was looking for execution costs around 3 basis points. So, the trading
desk began monitoring trading activity in the secondary market for the two ETFs, looking for
opportunities to buy and sell smaller portions of the total at 3 basis points. This process was a
migration of the products rather than an all-in trade. It ultimately helped the client toward her goal
of exchanging the two ETFs.

This example illustrates a remarkable fact about higher yield sectors of the bond market. The
the ETF market — that in a number of fixed income high yield bond ETF HGY, for instance, frequently
markets, ETF liquidity can far outstrip that of the trades more efficiently than its underlying portfolio,
underlying securities. Consider, Treasury ETFs, as does EDM, the emerging market bond ETF.
for instance, which are based on the most liquid As a result investors are increasingly directing
market in the world; in theory, there is an almost their trades through the ETF secondary market,
unlimited pool of potential securities to buy and which in turn, for now, increases liquidity in
sell. Yet recently, Treasury markets have become these ETFs.
less liquid, particularly when you are trading
specific issues. As a result, index pools that are In every instance, the key to cost-effective trading
not concentrated in one specific Treasury actually is an in-depth understanding of the ETFs in the
become more liquid at one price point because transaction, as well as the underlying securities
they can in theory trade inside the arbitrage they track.
bounds. This can also occur in the higher risk,



Trading ETFs of Restricted Currencies
ETFs have provided a convenient, liquid mechanism for investing in currencies, particularly those
where foreign exchange controls make it difficult to execute transactions in the currency itself.
However, many of the ETFs that focus on these currencies are relatively small, so executing large
transactions can create significant market impact, or friction. By using all sources of liquidity including
futures, however, it is possible to make even very large trades with minimal market impact.

Consider the situation of a hedge fund manager who wants to unwind a large position in an
emerging market currency ETF quickly. The ETF trades only a few thousand shares a day. The
hedge fund manager wants to close out a position worth upwards of 20 million shares. The Cantor
ETF trading desk handled the trade with minimal market impact.

The size of the ETF relative to the proposed trade ruled out execution in the secondary market.
The underlying assets — that is, units of the currency — were restricted from trading by foreign
exchange controls. To find liquidity, the ETF trading desk tapped a much larger, more liquid
non-deliverable forward or NDF market.

A non-deliverable forward (NDF) is a cash-settled, short-term forward contract on a thinly traded or

non-convertible foreign currency. When an NDF expires, the buyer receives the difference between
the exchange rate set when the NDF is purchased and the actual rate at the time of settlement.
These contracts allow buyers to benefit from gains and losses in the value of the currency, without
any possibility of ever receiving the currency upon settlement.

The traders tapped multiple NDF dealers and began selling NDF contracts in quantities small
enough to minimize market impact. A time-weighted, average price strategy helped smooth out
fluctuations in market impact. When enough NDFs had been sold, the trading desk returned the
ETF to the issuer and, through the creation/redemption process, received NDFs in exchange. The
trade sourced deep liquidity from the underlying currency basket to avoid market impact.

Minimizing Costs in Commodity ETF Trading
ETFs and ETNs that invest in commodities have Consider the situation of a large portfolio manager
gained widespread popularity with institutional who seeks exposure to a broadly based commodity
and retail investors who previously did not have index with a heavy weighting in energy, just as
access to commodities markets. Investors can weakness in crude oil drives major commodities
now gain exposure to energy, precious metals, indices drop to new six-year lows. The portfolio
industrial metals and agricultural commodities manager decides to use a low cost ETF that
without having to manage some of the more tracks nearly 20 different commodities via futures
restrictive features of futures or holding the across different months on the futures calendar.
physical commodity. These features, which include The ETF volume averages approximately 4,000
large contract notional amounts, periodic rolls, shares daily and has 1,500,000 shares outstanding,
margin considerations, metals storage and and the portfolio manager would like to trade
insurance, etcetera, are instead managed by more than 11,000,000 shares. The Cantor ETF
the fund, while the investor can trade and invest desk was able to show a risk price equivalent to
in the ETF like a traditional equity. Additionally, approximately 6 basis points impact relative to
most widely followed commodities indices are the current National Best Bid Offer at the time.
tracked by ETFs or ETNs, allowing investors to Furthermore, the trade occurred after the cutoff
gain exposure to the world’s most consumed time at which one can create shares of the ETF
commodities in one liquid product. directly with the ETF issuer.



The trader was able to access the underlying U.S. and London-listed futures, building a portfolio to
closely track the ETF’s underlying index. He did this by trading both the actual contracts tracked by
the index outright where liquidity permitted, as well as a combination of liquid front month contracts and
calendar rolls where liquidity in the outright contract did not permit. The positions were held for
two days, with the trader managing the risk of any index changes, so that the settlement date of
the original trade and the settlement date of the ETF creation, which is one day after the creation
trade date with the issuer, would match up and minimize the cost of holding the position.

On the creation date, the trader placed the order with the ETF issuer, with the price of the creation
benchmarked to that day’s closing NAV, based on the closing prices of the underlying futures,
which close at different times between 11AM and 3PM EST. The trader then unwound his futures
hedges, targeting the close in the underlying futures via Trading at Settlement (TAS) contracts,
a combination of front month futures contracts and calendar rolls, and executing around futures
settlement times.

The Keys to Minimizing Trading Impact
Not all ETF desks can execute minimal impact exchanging ETF shares for their underlying baskets
trades, since accessing liquidity requires considerable or vice versa.
expertise and market knowledge. It is especially
critical to understand the structure and characteristics And finally, firms with large balance sheets and
of the ETFs being traded; even minor differences diverse holdings in ETFs and their components
in basket construction can significantly affect are able to bring ETF trades onto their own balance
trading strategies. sheets, further reducing market impact.

Cost-effective trading requires direct access to As ETFs become more integral to both institutional
markets, both the secondary market where ETFs and retail investment strategies, investment managers
trade and the primary ones where the underlying will necessarily focus more intensely on execution
securities are bought and sold. Firms who are costs in which market impact can be the largest
authorized participants, that is, who are able to component. Trading strategies can increase portfolio
participate in the creation/redemption process, performance by reducing the drag of market impact
can take advantage of liquidity in either market by and help deliver higher returns to investors.

For more information about how more cost-effective trading can help your firm meet its goals, contact:

110 East 59th Street 1 Churchill Pl, Canary Wharf

New York, NY 10022 London E14 5RB, United Kingdom
+1 212-938-5000 +44 20-7894-7000




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