Creation and redemption process in primary market happens only between Authorised Participants (AP) and ETF sponsor/issuers. It occurs once a day, after market close, priced at Net Asset Value (NAV) — the fund official closing price.
ETFs at the secondary market trade continuously during the day at the market price, or bid/offer price, which is different to NAV.
Retail investors with small investment budget buy and sell ETFs at the secondary market during the market open. The purchase or sale of ETFs is better off to be transacted via limit order instead of market order.
Nov 2019 ~ 6 mins read
Depending on the investor’s types, trading sizes and the main purposes, ETFs can be bought and sold in many different ways.
Chart 1. The Comparison of Primary and Secondary Market of ETFs
Retail investor with small investment budget would buy and sell ETF on an intra-day basis on an exchange, investment platforms or other trading venues which quote a bid/offer price. Buy and sell orders that are executed at a live market price is called screen transactions or exchange transactions.
Institutional investors with large investment capital often don’t want to disclose the size and direction (buy or sell) to the market. In such cases, institutional investors prefer to negotiate the deal privately with brokers, banks or other counterparties. Trade that are transacted outside the open market, at a price and size unknown to the market is called OTC (over-the-counter) transactions.
In ETF space, both screen and OTC activities happen in the secondary market. Most investors transacted at the secondary market interact with each other, brokers, market makers, or Authorised Participants (AP) maker to buy or sell ETF shares. Unlike mutual funds, ETFs traded in secondary market never interact with ETFs issuers. Buying and selling ETFs in the secondary market are simply a change of ownership. It doesn’t result in increase or decrease of ETF share, therefore there are no changes to ETF’s AUMs (assets under management).
Institutional investors with trading size that is even larger what’s available on-screen, in OTC market, or exceeds the average daily volume (ADV) of the ETF, will deal with ETF issuers directly via APs. APs who exclusively enter agreement with ETF issuers can exchange ETF shares with cash or underlying securities. The newly created or redeemed ETF shares then return to investors to meet their investment need.
This process is happening in Primary Market. Buy or sell orders that cannot be met in the secondary market will be aggregated to APs, who will transact with ETF issuers directly to create or redeem ETF shares. The creation and redemption process results increase or decrease of ETF shares available in the secondary market, which then affects ETFs’ AUMs.
For the creation process, APs assemble and delivery underlying securities of the fund or cash to ETF issuers/sponsors. In return, the APs receive ETF shares which then introduced to the secondary market or to investors directly.
The redeem process is the reverse. Incremental ETF shares are collected in the secondary market by APs, who then deliver to the ETF sponsor/issues, in exchange for the underlying securities of the ETF or cash.
Chart 2: How investors interact with ETF market
Creation and redemption process in primary market happens only once a day, after market close, priced at Net Asset Value (NAV).
ETFs at the secondary market trade continuously during the day at the market price, or bid/offer price
NAV (Net Asset Value): It is calculated once per day after the market close, based on the most recent closing prices of the underlying securities. It represents the fair value of ETFs based on which ETF shares are transacted between Authorised Participants (AP) and ETF issuers. This is not the price for ETF intraday trading.
To gain intra-day indicative estimate of ETF’s value per share over the course of the trading day, ETF also publishes iNAV (Indicative net asset value)
iNAV (Indicative net asset value): also called the IOPV (Intraday Optimised Portfolio Value)), is calculated every 15 seconds or longer intervals. It is an intraday indicative NAV, however it is not the official NAV per share as determined in accordance with the prospectus, neither the transactional price where the buy or sell order is based on.
iNAVs are disseminated during the day. AP, market makers or institutional investors also make their own real-time assessment, which may different to iNAV.
Bid/Offer or market price: The real-time market price where the market willing to buy or sell ETF shares. Bid/Offer or market price tracks very closely to iNAV price, but not necessarily the same.
Market price of ETF is determined based on demand and supply. When it is share does not equal to its NAV, a premium/discount exists. market makers will generally take advantage of differences between the NAV and the trading price of ETFs shares through arbitrage opportunities. The arbitrage keeps the market price of ETFs aligned with its NAV or iNAV.
Chart 3: The differences between NAV, iNAV, and Market Price (bid/offer price)
For retail investors with small invested amount per transaction, ETF trades like stocks. Most trading platforms will display a bid (a lower price that the market would like to buy from you) and an offer (a higher price that the market would like to sell to you) price.
There are two ways to submit a buy or sell order.
Market order where investors simply enter the quality to buy/sell, and the order is guaranteed to be executed immediately at whatever price the order gets filled.
Limit order where investors specify a quantity, as well as a purchase price (lower than the best bid) or a sell price (higher than the best offer), in this case the orders will only be executed when the market reaches the limit order price. Limit order guarantees the transactions prices as specified by the investor, but not the fulfilment of orders.
Even investors prefer to execute the order immediately at the current market price, it is recommended to investors to submit limit order at a price close to bid/offer, instead of a market order.
Limit order is always recommended than market order for three reasons:
From the moment when investors decide to place an order, to the moment when the order gets filled, the market might have moved a lot within a few seconds. This can be result from large order flow institutionals that might move the market, big volatility introduced by market event, e.g. economic stats, central bank announcement or fat fingers. Implicit losses introduced by this type of slippages can range from 1–2% to 10–20% in an event of market crash.
Bid/Offer price quoted on most investment platforms are wider than the best bid/offer shown on the exchange or institutional market places. Most investment platforms embed a business model to make a few basis points between prices fulfilled for investors’ orders and the price traded at the exchange. By submitting a market, investors are guaranteed a loss between the market prices and the fulfilled price. Investors would have better controls of the filled price with a simple limit order.
When investor’s order size is large or the liquidity for the chosen ETF is thin, order sizes that cannot be filled at the best bid/offer will search down the order book, and get fulfilled at a much worse price. In contrast, if investors submit a limit order, part of the order sizes that cannot be met with the market price will stay unfilled. Chart 4. Limit order vs. Market order, and its implications for large and small ETF transactions
Chart 4. Limit order vs. Market order, and its implications for large and small ETF transactions