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
vehicles, short and mid-term holding vehicles,
parking, active strategy replication and instant
exposure to asset classes, more and more
market participants have begun to look at
market impact. Talk about entering trades at
net asset value without moving the market has
moved from hypothetical conference conversation
to an everyday reality for institutions.
The ETF market has grown sharply in recent
years, accounting for an ever-larger share
of both institutional and retail assets under
management. Institutional investors now
hold more than $1 trillion in ETFs, representing
nearly half the $2.6 trillion total (as of 01/2017).
1
“Being Traded Has Eclipsed U.S. GDP,” by Eric Balchunas, Bloomberg, July 30, 2015.
http://www.bloomberg.com/news/articles/2015-07-30/the-amount-of-etf-shares-being-traded-has-eclipsed-u-s-gdp
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At the same time, hedge funds, financial planners
and smaller institutions have expanded their
use of ETFs, as have fast-growing market
segments such as robo-advisors and other
model-based portfolio strategies that must be
regularly rebalanced.
These investors are taking advantage of the
liquidity ETFs offer, even in asset classes that
are not otherwise easily traded, such as foreign
securities, currencies, bonds and commodities.
Employing ETFs in these asset classes can be
the quickest method of expressing a market
perspective or investment theme, and can, by
itself, significantly reduce trading costs.
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.

2.
Multiple Sources of ETF Liquidity
In order to understand how to minimize trading
impact, it may be helpful to review how ETFs
are constructed. The process begins when a
market maker, designated as an authorized
participant, assembles a basket of securities that
replicates the ETF’s index or target portfolio. The
authorized participant delivers these securities
to the ETF’s custodian, who in exchange, gives
the authorized participant a “creation unit.”
The creation unit is a large unit, which can be
broken into ETF shares and sold on the
public market.
The authorized participant can create or redeem
ETF shares at any time. If there is a sudden
demand for a large block of ETF shares — for
instance, if a large institutional investor wants
to initiate a position in the ETF — the authorized
participant can buy the underlying securities
and create new ETF shares. If, by contrast, an
investor wants to sell a large position, the
authorized participant can break the ETF into its
underlying components and sell these securities.
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As a result, there are almost always multiple
sources of liquidity for ETF investors: the liquidity
of the ETF itself, as it trades on the secondary
market, and the liquidity of the underlying basket
of securities that the ETF holds. In addition,
other sources of liquidity may exist in the futures
and derivatives markets. To execute trades
that do not move the ETF’s market price very
much, traders must look at all sources of
liquidity and choose a strategy that will have
the least possible impact.
The chart below compares bid-ask spreads in
the ETF and the underlying basket of securities
for seven widely held ETFs. As you’ll see, in all
seven cases, the spread in the ETF is smaller
than that of the underlying basket of securities.
That’s consistent with the experiences small and
mid-sized investors have had in the ETF market
– that is simpler and more cost-efficient to trade
the ETF than the underlying securities.
 ETFs TIGHT ID/ASKs, DEEP LIQUIDITY

SPY IWM EEM LQD QQQ MDY JNK

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.

4.
Trading in Global Equities
Global equities poise a multifaceted set of issues,
from currency, to the movement and liquidity of
underlying equities trading on multiple markets,
in multiple time zones simultaneously. A large
global money manager wanted to move $1
billion in assets out of two ETFs with regional
market exposure, specifically Europe and Japan,
into a lower cost, more liquid ETF with a global
mandate. The simplest strategy — selling around
a half a billion each from the regional ETFs and
buying a billion in the global one — would
have a market impact of approximately 60 basis
points, roundtrip.
Upon further examination, the global ETF and
the two regional ones owned many of the same
companies. About 60% of the trade would involve
simply moving the Japanese stocks held by the
Japan ETF and the European stocks held by the
European ETF into the global ETF.
One alternative would be to use the creation/
redemption process to break the two regional
ETFs into their component stocks and then
exchange those stocks, plus or minus any
differences in holdings, for shares in the global
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ETF. However, the creation/redemption process
entails its own trading costs and tax liabilities,
influencing the cost of the transaction.
In this case, the solution was to use our balance
sheet to execute the exchange. Traders bought
blocks of shares in the two regional ETFs, broke
them down into their individual components and
paired their risks with long and short positions in the
trading desk’s proprietary portfolio of roughly
400 ETFs. Then, the trading desk worked to
trade out of our position while managing risk.
The transaction was executed for less than 5
basis points, saving the customer approximately
$3 million.
Our focus on limiting costs for this trade gave
this customer the flexibility to reallocate a large
portion of his portfolio into a lower cost, more
liquid vehicle, which may reduce the cost for
monthly rebalancing in the future. If the investment
manager had to pay the full cost for trading
between the three ETFs in the secondary market,
he may not have made the shift due to market
impact (friction). Executing the trades will benefit
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.

6.
This example illustrates a remarkable fact about
the ETF market — that in a number of fixed income
markets, ETF liquidity can far outstrip that of the
underlying securities. Consider, Treasury ETFs,
for instance, which are based on the most liquid
market in the world; in theory, there is an almost
unlimited pool of potential securities to buy and
sell. Yet recently, Treasury markets have become
less liquid, particularly when you are trading
specific issues. As a result, index pools that are
not concentrated in one specific Treasury actually
become more liquid at one price point because
they can in theory trade inside the arbitrage
bounds. This can also occur in the higher risk,
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higher yield sectors of the bond market. The
high yield bond ETF HGY, for instance, frequently
trades more efficiently than its underlying portfolio,
as does EDM, the emerging market bond ETF.
As a result investors are increasingly directing
their trades through the ETF secondary market,
which in turn, for now, increases liquidity in
these ETFs.
In every instance, the key to cost-effective trading
is an in-depth understanding of the ETFs in the
transaction, as well as the underlying securities
they track.
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.

8.
Minimizing Costs in Commodity ETF Trading
ETFs and ETNs that invest in commodities have
gained widespread popularity with institutional
and retail investors who previously did not have
access to commodities markets. Investors can
now gain exposure to energy, precious metals,
industrial metals and agricultural commodities
without having to manage some of the more
restrictive features of futures or holding the
physical commodity. These features, which include
large contract notional amounts, periodic rolls,
margin considerations, metals storage and
insurance, etcetera, are instead managed by
the fund, while the investor can trade and invest
in the ETF like a traditional equity. Additionally,
most widely followed commodities indices are
tracked by ETFs or ETNs, allowing investors to
gain exposure to the world’s most consumed
commodities in one liquid product.
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Consider the situation of a large portfolio manager
who seeks exposure to a broadly based commodity
index with a heavy weighting in energy, just as
weakness in crude oil drives major commodities
indices drop to new six-year lows. The portfolio
manager decides to use a low cost ETF that
tracks nearly 20 different commodities via futures
across different months on the futures calendar.
The ETF volume averages approximately 4,000
shares daily and has 1,500,000 shares outstanding,
and the portfolio manager would like to trade
more than 11,000,000 shares. The Cantor ETF
desk was able to show a risk price equivalent to
approximately 6 basis points impact relative to
the current National Best Bid Offer at the time.
Furthermore, the trade occurred after the cutoff
time at which one can create shares of the ETF
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.

10.
The Keys to Minimizing Trading Impact
Not all ETF desks can execute minimal impact
trades, since accessing liquidity requires considerable
expertise and market knowledge. It is especially
critical to understand the structure and characteristics
of the ETFs being traded; even minor differences
in basket construction can significantly affect
trading strategies.
exchanging ETF shares for their underlying baskets
or vice versa.
And finally, firms with large balance sheets and
diverse holdings in ETFs and their components
are able to bring ETF trades onto their own balance
sheets, further reducing market impact.

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

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

CantorETFs.com

110 East 59th Street 1 Churchill Pl, Canary Wharf

New York, NY 10022 London E14 5RB, United Kingdom
etf@cantor.com etfeurope@cantor.co.uk
+1 212-938-5000 +44 20-7894-7000

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