Trading ETFs in the Secondary Market by Wesley R. Gray, Ph.D., Alpha Architect

Our mission is to empower investors through education. So train yourself well, in order to think critically about your own financial situation. An educated investor can defend against the financial services industry, which is a marketing juggernaut, and doesn’t always have your best interest in mind.

The focus for today is understanding how markets are made in ETFs. As it turns out, market making for ETFs differs in some fundamental ways from the type of market making associated with other listed securities.

We recently had a great interview with Chris Hempstead, a big shot over at KCG, one of the largest ETF market makers in the world. Chris’ final words:

Ask questions.  Get comfortable. Ask more questions.  DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot.  You are not investing in volume. You are investing in a product that tracks an index.  If you can efficiently buy and sell the optimal product, other people’s volume is the least of your concerns.  Find a broker that understands how to access the cheapest and most efficient liquidity at the moment in time you need to trade.

Chris really set the stage for this discussion and answered some burning questions many of you probably had in the back of your mind.

How Markets are Made in ETFs

An ETF is simply a basket of securities that are publicly traded in the marketplace. Consider an ETF that holds 2 stocks: MSFT and INTC.

Throughout the day, there is an “INAV,” or intra-day net-asset-value, which tracks the value of an ETF on a 15-second basis. The INAV will be based on the prices associated with MSFT and INTC. Unfortunately, INAVs are not always 100% accurate, and by design, they can be up to 15-seconds delayed. 15-seconds doesn’t sound like a long time, but in the context of intra-day markets, 15-seconds can be an eternity.

Because INAV values can have issues, market makers and ETF sponsors maintain a separate, real-time price on their ETF. On a tick-by-tick basis market makers track the “true” value of an ETF.

Market makers don’t track the tick-by-tick value of an ETF for their health–they do it so they can make money! Market makers are in the business of making markets, which costs money. Someone has to buy the computers, pay the employees, and pay the rent to keep the lights on at the market making shop.

One way the market maker makes money is by creating a bid/ask spread around the ETFs true tick-by-tick value. For example, let’s say the value of the underlying basket of stocks in an ETF is worth $25. A market maker might post a bid at 24.95 and post an ask of 25.05. So if someone wants to sell the ETF, they will get 24.95, not $25. The 5 cent difference goes to the market maker. Similarly, on the buy transaction, an ETF buyer will pay $25.05 for the ETF. The buyer will get an asset worth $25, and the 5 cent premium will go to the market maker for making a market in the ETF.

Here are some example limit books from 11/26 (~9:35am) on PIZ, IWM and SPY.

PIZ trades in international markets; IWM trades in small-cap stocks; SPY trades in mid/large cap stocks.


The spread is 9 cents, or roughly a 4bps spread on either side. Pretty liquid. (Note: the $24.95 is the last trade)

Trading ETFs


The IWM has a 1 cent spread on either side, or ~1bp. Incredibly liquid.

Trading ETFs


SPY is incredibly liquid and the spread is 1 cent, or 1/2 a cent on either side. This is essentially “free” for all intents and purposes.

Trading ETFs

How is the Spread Priced?

Investors often confuse the liquidity of an ETF with the “volume” in the shares of the ETF. But this is not the right way to think about it. As Chris highlighted in his interview:

DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot.  You are not investing in volume.  You are investing in a product that tracks an index.
What is Chris talking about?

Well, if you notice the 3 limit books from above, they have three different spreads and trade in three different asset classes. You’ll also notice that the PIZ book is less liquid than the IWM book, and the IWM book is less liquid than the SPY book.

Of course, a big part of the “visible” liquidity in these three different limit books is driven by the popularity and interest in these ETFs. And while popularity and interest certainly contribute to liquidity, the real driver of liquidity in an ETF is the liquidity of the underlying assets that the ETF holds. The reason why the liquidity of the underlying assets is so important to ETF liquidity has to do with how the market makers make a profit, which we’ll get to in a minute. Certainly, the liquidity of the underlying assets helps describe the spreads in PIZ, IWM, and SPY observed above. In general, international stocks (PIZ) are less liquid than Russell 2000 stocks (IWM), and US small-caps (IWM) are less liquid than S&P 500 stocks (SPY). The spreads on these three ETFs seem to match up with the liquidity of the stocks they contain.

This intuition underlying this concept is set forth in the chart below, which has four quadrants. Note how in quadrant 1 (upper left), illiquid underlying assets result in an illiquid ETF, and in quadrant 2 (upper right) liquid underlying assets result in a liquid ETF. There are two important corrolaries here for ETF investors. In quadrant 3 (lower left) illiquid underlying assets DO NOT result in a liquid ETF. In quadrant 4 (lower right) liquid underlying assets DO NOT result in an illiquid ETF.

Trading ETFs

Why is liquidity in an ETF driven by the liquidity in the underlying?

This underlying liquidity matters, because it is the liquidity of the underlying assets that determines how market makers create the “spread,” and in a profitable way that ensures their own ongoing solvency.

Market makers, specifically authorized participants (APs), can arbitrage differences between the net-asset-value (NAV) of an ETF and the value of the underlying ETF holdings.

At every given point in the day, an AP is calculating the cost to buy the basket of securities that form an ETF, and the cost of selling a basket of securities that form an ETF. They compare these two “theoretical” portfolios to the live net asset value of the ETF.

Let’s work through an example so you can understand how these market makers think.

Consider the “TECH” ETF that holds 1 share of MSFT and 1 share of INTC. Let’s say MSFT’s bid/ask is 47.31 by 47.35 and INTC’s bid/ask is 36.49 by 36.51. This means that an investor can buy MSFT at 47.35 and buy INTC at 36.51. This also implies that an investor can sell MSFT at 47.31 and sell INTC at 36.49.

Let’s say the current live net-asset-value based on mid-point prices on TECH is  83.83. The market maker will

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