THE ETF TOOLKIT THIRD EDITION THE PROFESSIONAL S GUIDE TO EXCHANGE-TRADED FUNDS

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1 THE ETF TOOLKIT THE PROFESSIONAL S GUIDE TO EXCHANGE-TRADED FUNDS THIRD EDITION Not FDIC Insured May Lose Value No Bank Guarantee For Institutional Investor Use Only Not For Use with the Public

2 Contact us ETF overview ETF structure NAV and IOPV ETF pricing Components of ETF liquidity Secondary markets Alternative methods of execution Shorting ETFs Important information For Institutional Investor Use Only Not For Use with the Public 2

3 About the authors This guide was produced by the Invesco ETF Capital Markets team, an integrated group of professionals that serves as the hub to the ETF ecosystem for Invesco ETFs. The team s three core functions are: Liquidity and execution services: Assisting financial advisors and institutional clients through the ETF trading process, by assessing the potential liquidity of Invesco ETFs, developing a client-specific trading strategy and evaluating the potential impact of trades. Market maker and authorized participant relations: Working with various market making firms, authorized participants and other sell-side firms to ensure consistency in the secondary markets they provide. Additionally, the team continuously monitors secondary market activity by assessing and tracking market maker performance, evaluating spreads and monitoring trading activity. Research and content: Providing actionable market commentary by assimilating and distilling high quality buy-side and sell-side research into ETF investment strategies and providing market perspectives. Here are just a few services Invesco ETF Capital Markets provides: Pre-trade analytics: Helps assess liquidity Bloomberg terminal ETF assistance: Educates on how to properly screen/ compare ETFs Weekly trading report: Provides industry trends and flows Weekly options report: Provides a snapshot of the ETF options industry Monthly spread and impact report: Helps assess the impact of large trades Monthly snapshot: Gives an overview of ETF industry flows by asset and highlights of relevant trends within the Invesco ETF lineup ETF implementation strategies and trade ideas: Provides timely market commentary and actionable trade ideas Contact Invesco ETF Capital Markets to access these services and more. invesco.com/ capitalmarkets capitalmarkets@ invesco.com For Institutional Investor Use Only Not For Use with the Public 3

4 Contact us ETF overview ETF structure NAV and IOPV ETF pricing Components of ETF liquidity Secondary markets Alternative methods of execution Shorting ETFs Important information For Institutional Investor Use Only Not For Use with the Public 4

5 ETF overview The first ETF launched in the US in It has since grown to $302 billion in assets under management (AUM), trading an average of 87 million shares per day. 1 Wondering about the huge growth of ETFs and if/how they are affecting valuations of individual equities or fixed income? Contact us for our analysis on the topic. Over the past 20+ years, ETFs have grown tremendously in terms of AUM and number of products. They now span virtually every asset class. Over the past five years alone, ETF AUM has grown at a compound annual growth rate of 17%, as more investors have taken advantage of the 1, 2, 3 low-cost, liquid, transparent and tax-efficient nature of this vehicle. As of December 31, 2017, there were more than 2,096 U.S.-listed exchange-traded products and total AUM was greater than $3.6 trillion. 4 With the increased usage of ETFs across all investor segments and channels, the trading volumes in ETFs have also increased. ETF industry growth AUM ($billion) Source: Bloomberg L.P., as of Dec. 31, 2017 Average ETF trading volume per day in 2017 was $68.8 billion 5 Average ETF trading volume (as percentage of total equity volume) 29% 28% 27% 26% 25% 24% 23% 22% 21% Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec. Source: Bloomberg L.P., as of Dec. 31, Source: Bloomberg L.P., as of January 25, Transparency: ETFs disclose their holdings daily. 3 Low cost: Since ordinary brokerage commissions apply for each buy and sell transaction, frequent activity may increase the cost of ETFs. 4 Source: PowerShares Product Strategy Research, as of December 31, Source: Bloomberg L.P., as of Dec. 31, 2017 For Institutional Investor Use Only Not For Use with the Public 5

6 Contact us ETF overview ETF structure NAV and IOPV ETF pricing Components of ETF liquidity Secondary markets Alternative methods of execution Shorting ETFs Important information For Institutional Investor Use Only Not For Use with the Public 6

7 ETF structure What is unique about ETFs? A key difference between ETFs, mutual funds, separately managed accounts (SMAs) and collective investment trusts (CITs) is that ETFs are traded on national exchanges rather than through fund managers at a daily net asset value (NAV). Although they trade on an exchange similar to individual equities, they have the unique capability of expanding or contracting shares outstanding on a daily basis. Most ETFs are established under the Investment Company Act of 1940 with exemptive relief, therefore, they are nuanced in their tradability and ultimately in their creation and redemption process. Another key difference between traditional mutual funds, SMAs and CITs when compared to ETFs is centered around how investors fund positions. ETFs are listed securities that trade on national exchanges, such as NYSE ARCA, NASDAQ and BATS. Investors buy and sell ETF shares through their brokerage accounts and trades are printed to the consolidated tape. Institutional traders make markets in ETFs by quoting bids and offers and managing ETF inventory positions. These institutional traders can then bundle up smaller ETF orders into larger positions and create or redeem shares of the ETF by dealing directly with the ETF manager and the custodial bank. ETF shares are created (issued) and redeemed (retired) in large, predefined block sizes by these institutional traders. Conversely, mutual funds, SMAs and CITs allow investors to deal directly with the fund manager, who accepts cash from the investor in exchange for new units issued by the fund at net asset value. Given the exchange-traded nature of ETFs, it is critical for investors to understand how to efficiently trade, as they must interact directly with the capital markets when buying and selling ETF shares. Creation/redemption To better understand how shares are created and redeemed, let s look at how the process differs from mutual fund creation and redemption. Mutual fund creation When new money flows into a mutual fund, the fund manager either uses the cash to purchase securities in the open market or maintains this cash position. Creation flow Investor $ Cash Units Mutual fund $ Cash Stock Market For illustrative purposes only. SMA: Separately managed account; A pool of assets that is managed by an investment management firm for the benefit of an investor. NAV: Net asset value; The value of all assets in a fund, minus any liabilities, divided by total shares outstanding. NAV is calculated by the custodial bank and is disseminated once daily. Investment Company Act of 1940: Act of Congress passed in 1940 which represents the primary source of regulation for open- and closed-end funds. Exemptive relief: Regulatory order granted to ETF fund complexes to provide exemption from certain provisions of the Investment Company Act of 1940 necessary to operate within the ETF structure. For Institutional Investor Use Only Not For Use with the Public 7

8 Mutual fund redemption When mutual funds are redeemed, the fund manager must deliver cash back to the investor at NAV. As a result, the mutual fund manager may be required to sell securities in the open market to raise cash or maintain a cash balance in order to deliver cash back to the investor. Redemption flow Investor Sell $ Cash Mutual fund Sell $ Cash Market For illustrative purposes only. ETF creation/redemption ETF shares are created and redeemed in block sizes by large institutional traders called authorized participants (APs). The number of ETF shares that represent the block size that APs create/redeem is referred to as the creation unit and is defined in the prospectus of each ETF. Most ETFs in the United States create and redeem in predefined sizes ranging from 10,000 to 200,000 share blocks. Authorized participants (APs): Market participants who have a legal contract (AP agreement) in place with an ETF trust and the custodial bank which permits them to create and redeem shares of the ETF. For Institutional Investor Use Only Not For Use with the Public 8

9 The ETF structure, while still open-ended, can handle the creation/ redemption in one of two ways: In-kind: APs will exchange a predefined basket of securities to the ETF issuer s custodial bank and receive a block of ETF shares. For redemptions, APs receive a predefined basket of securities in exchange for ETF shares. In both the creation and redemption, the basket shares are exchanged in-kind between the custodial bank and the AP. (See below.) Cash: APs will exchange cash to the custodial bank for a block of ETF shares equal to the creation unit. Similarly, in cash redemptions, APs will receive cash equal to the redemption unit and the custodial bank will retire the ETF shares. Behind the scenes In-kind creation In-kind redemption Basket of securities Basket of securities Custodial bank APs Custodial bank APs ETF units ETF units For illustrative purposes only. In-kind creation and redemption: Refers to the process which allows for shares to be created and redeemed by swapping ETF shares for the underlying constituents of the ETF. Custodial bank: ETF issuers use custodial banks to hold the underlying securities of each ETF in street name (electronically) and process the creation/redemption orders from the AP on behalf of the ETF issuer. Cash creation or redemption/cash-in-lieu (CIL): When an AP delivers cash to an ETF issuer to create new ETF shares, or receives cash back from the ETF issuer when redeeming shares. For Institutional Investor Use Only Not For Use with the Public 9

10 ETF tax efficiency The majority of creations and redemptions in US-listed ETFs are effected in-kind. Tax efficiencies are created because the ETF does not recognize any gain or loss for tax purposes from the securities removed from the portfolio. The primary source of the tax efficiency provided by many ETFs comes from the fact that the majority of an ETF s buy and sell activity takes place on the exchange and away from the ETF. Meaning the ETF does not need to buy or sell any securities in response to these trades. Behind the scenes mechanics ETF issuers must publicly disseminate a daily basket file for each ETF, which lists the securities and cash held for one creation unit. The basket file provides transparency to APs and market makers so they re informed of the securities and/or cash that needs to be delivered to/received from the custodial bank for each creation unit. Partial sample of a daily basket file Invesco BuyBack Securities Achievers ETF Ticker PKW CUSIP Name Basket shares Price Component count V109 ACTIVISION BLIZZARD 1,008 $20.75 CU Estimated cash $1, J106 ADT CORP/THE 246 $34.79 Projected NAV $ A106 ADTRAN INC 77 $22.59 Shares outstanding 57,200, T100 AECOM 217 $25.95 CU 50, AIRGAS INC 105 $ CUSIP 46137V ALBEMARLE CORP 110 $47.77 Standard CUSIP 0000S G106 ALLIANCEBERNSTEIN HOLDING LP 137 $24.82 For illustrative purposes only. Basket file: A file published daily by the ETF issuer, disclosing the securities and cash required for one creation unit. Market maker: A dealer who undertakes to buy or sell in a security at specified prices by quoting bids and offers. Creation unit: The specified number of ETF shares that represent one unit of the fund. This is the block share quantity that APs must deal in when interacting with the trust for creation or redemption. It is typically 10,000, 50,000, 75,000, 80,000, 100,000, 150,000 or 200,000 shares and is specified in each ETF s prospectus. For Institutional Investor Use Only Not For Use with the Public 10

11 When an ETF experiences buying pressure, liquidity providers may be able to meet demand by selling their inventory positions. If the liquidity providers do not have inventory in the ETF, they may sell ETF shares short, while simultaneously buying the underlying basket of securities as a hedge. These offsetting trades allow the liquidity provider to reduce directional market exposure. Often times, the goal of the liquidity provider is to profit from the bid/ask spread, while minimizing risk. Once APs have accumulated the requirements for a creation unit, they will exchange the underlying basket of securities for ETF shares with the custodial bank. The opposite process is true for redemptions. APs will buy shares of the ETF from investors while simultaneously shorting the underlying basket (or a correlated hedge). At the end of the day, they may redeem the ETF shares to the custodial bank and receive back the underlying basket, thereby flattening their position. Provide liquidity. Lock in spread. Hedge exposure. Sell ETF* Buy basket of securities Liquidity provider Buy ETF Buyer Creates ETF For illustrative purposes only. *These shares can be sold from inventory or sold short. Liquidity provider: A firm that is compensated through arbitrage or commission for the process of sourcing ETF shares for an investor. A liquidity provider may be a market maker or AP. For Institutional Investor Use Only Not For Use with the Public 11

12 ETF issuers use custodial banks to hold the underlying securities of each ETF in street name (electronically) and process the creation/redemption orders from the AP on behalf of the ETF issuer. APs in the US are typically large financial institutions that must be self-clearing broker dealers, US-based and Depository Trust Company (DTC) members. An AP is charged a pre-defined fixed and/or variable fee by the ETF issuer s custodian to create or redeem shares of an ETF. This fee is paid by the AP and is called the creation/redemption ticket charge. The creation/redemption processes and fees are unique to each ETF. As mentioned earlier, there are circumstances where creations/redemptions are handled via a cash create/redeem or, at times, a CIL process. With cash creations, APs are required to deliver cash equal to the NAV of the securities in the underlying basket in order to create new shares of an ETF. For cash redemptions, APs receive cash back for their ETF shares based on the NAV of the fund. The standard creation/redemption process of an ETF, whether in-kind or cash, is defined in the ETF prospectus. However, in certain circumstances, the ETF issuer may allow APs to use custom baskets. This may be done to help APs avoid restrictions they may face when transacting in a particular security. For example, if the AP is restricted in dealing in a particular component, they may seek to deliver the cash value for this security and use a custom basket which excludes the restricted security. Fixed income ETF structure The fixed income market is generally an over the counter (OTC) market where trades are often negotiated privately between parties, and trade data may not be as readily available as it is for equities. Parties can have different viewpoints on pricing, based on inventory, and the same instrument may trade at multiple prices in a short period of time. The fixed income market is more opaque and many corporate or municipal bonds trade less frequently than their equity counterparts. Some corporate bonds may go days without trading, making them more difficult to price. ETFs holding fixed income instruments bring a new dynamic to the landscape, as the ETF has full transparency. Larger fixed income ETFs can trade millions of shares per day. With this type of volume, liquidity providers need to have an idea of what the portfolio of bonds is worth, regardless of how frequently the underlying bonds have traded. The ETF may act as a price discovery vehicle for the underlying basket of bonds, as the liquidity providing community determines fair value for the basket. Creation/redemption ticket charge: The fee charged by the custodial bank to authorized participants creating and redeeming units of the ETF. Over the counter (OTC): Instruments that are traded off the exchange. For Institutional Investor Use Only Not For Use with the Public 12

13 Fixed Income creation and redemption The fixed income creation/redemption process is different from the equity creation/redemption process due to the OTC nature of the bond markets, and the disparate increments in which the bonds are transacted. With an in-kind fixed income ETF creation, it is rare that an AP would deliver all of the underlying securities in the basket, as fixed income securities typically trade by appointment. For example, the Invesco Fundamental High Yield Corporate Bond ETF (PHB), holds approximately 258 different bonds. For an AP to purchase all of the bonds in the basket would be inefficient and difficult to facilitate due to the relative scarcity of certain bonds. Instead, the ETF portfolio manager is in contact with the APs and market makers to request certain bonds in order to weight the ETF as close to its underlying index as possible. The AP would then deliver the requested bond(s) in-kind, plus or minus cash to arrive at the NAV of the fund for their creation. It may also be a practice with fixed income ETFs for an issuer to request the creation/redemption to be done via cash creation or cash redemption instead of in-kind. As an example, BKLN, the Invesco Senior Loan ETF, is typically created and redeemed via cash. Instead of delivering the underlying securities for a creation, the AP delivers cash to Invesco, the fund provider, who then purchases the underlying senior loans required for the fund. For ETF liquidity purposes, it is important to note that the trading hours of most fixed income securities are between 8 a.m. and 3 p.m. ET. ETFs, on the other hand, will continue to trade until 4 p.m. ET. This difference in closing times can affect a liquidity provider s ability to hedge an ETF trade, as they no longer have access to the underlying bonds that comprise the ETF. For the last hour of ETF trading, liquidity providers may use futures and other highly correlated instruments to hedge their ETF trades. 6 6 Depending on circumstances, it may be possible to trade bonds after the close. For Institutional Investor Use Only Not For Use with the Public 13

14 Contact us ETF overview ETF structure NAV and IOPV ETF pricing Components of ETF liquidity Secondary markets Alternative methods of execution Shorting ETFs Important information

15 Net Asset Value (NAV) and Indicative Optimized Portfolio Value (IOPV) Aside from publicly disseminating the basket of securities as required to meet the listing standards for Investment Company Units, ETF issuers are also required to publish the value of the underlying basket using two different methods: A NAV An Indicative Optimized Portfolio Value (IOPV) NAV NAV = All fund assets - liabilities total shares outstanding The NAV provides a daily snapshot of the value of the portfolio to the marketplace. Providing a NAV for the ETF based on the value of the underlying holdings is particularly useful for evaluating an ETF s performance over a specific time period (i.e. day/month/year). While the NAV calculation may be useful in providing a snapshot for end of day valuation purposes, it is not a trading tool for intraday valuation. As the underlying basket of an ETF fluctuates during the trading day, the value of the portfolio may deviate from the previous night s published NAV and appear to be trading at a discount or premium to NAV based on the basket s market movement. This should not be perceived as a discount or premium to the ETF s current fair value. Rather, it is the change in valuation based on the market movement of the underlying basket. For ETFs that have underlying basket components that close at times different from U.S. equity market close (i.e., international equity, fixed income and futures-based securities), the closing price of the ETF and the underlying basket value may deviate based on the market movement between when the basket closes and when the ETF closes. For Institutional Investor Use Only Not For Use with the Public 15

16 ETF NAV example: Invesco S&P 500 Low Volatility ETF (SPLV) As an example, the screenshot below shows the NAV for SPLV on Wednesday, January 23, 2018 at $ The order book (see next page) for SPLV on January 24, 2018 at 12:20 p.m., shows a bid/ask spread of $48.51/$48.52 and thus, SPLV appears to be trading at a $0.38-$0.39 premium to NAV. Despite the appearance of a premium, SPLV was actually trading in line with the value of the underlying holdings; January 24, 2018, was simply a day when the underlying stocks in SPLV had appreciated, leaving the prior day s NAV stale intraday. SPLV NAV SPLV orderbook Source: Bloomberg L.P. For illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public 16

17 IOPV Indicative Optimized Portfolio Value (IOPV) (also known as Intraday Indicative Value or IIV) is a helpful tool in determining fair value of an ETF intraday. It is calculated using the last print of each security contained in the ETF s basket. The Securities Exchange Commission mandates publishing the IOPV every 15 seconds. The figure tends to be more accurate for ETFs comprised of US domestic equities with frequently traded constituents, whereas ETFs comprised of international, futures or fixed income constituents that trade less frequently, may become stale. An example of this is an ETF that holds constituents that trade in the Japanese market. Due to the US/Japan time difference, the last trade of the Japanese constituent would be at 3 a.m. ET and trades would cease until the reopening of that market at 7 p.m. ET, so there would be no trading reflected in the IOPV calculation for that particular constituent. Due to the potential disconnect of trading times between certain international equity, fixed income, or futures-based ETFs, the IOPV may create the appearance of an ETF trading out of line with fair value. In this case, the ETF s pricing in the secondary market may be a better indication of fair value than the IOPV. As many liquidity providers are often simultaneously posting markets in a particular ETF, a mispricing by one liquidity provider would lead to an arbitrage opportunity by another liquidity provider. ETF pricing and the arbitrage mechanism will be discussed in detail in the next section. As with NAV, IOPV is a useful tool provided the calculation methodology and its limitations are fully understood. International market schedules that may impact NAV/IOPV New York: 9:30 a.m. 4 p.m. ET London: 3 a.m. 11 a.m. ET Tokyo: 7 p.m. 3 a.m. ET Indicative Optimized Portfolio Value (IOPV): Also known as IIV or Intraday Indicative Value, this is the statistical value of the underlying holdings of an ETF, which is published every 15 seconds and disseminated to the consolidated tape based on the last traded price of all the underlying constituents. This metric can be found on Bloomberg, as well as other financial sources. Fair value: The theoretical price at which the ETF is neither overpriced nor underpriced. For Institutional Investor Use Only Not For Use with the Public 17

18 IOPV domestic equity example Below, you can see the IOPV for SPLV at $48.48 on January 24, 2018, at 13:33. As you can see, this IOPV is in line with the bid/ask of SPLV on January 24, 2018 at 13:33 of $48.48/$48.49 as shown on the right. SPLV IOPV SPLV bid/ask Source: Bloomberg L.P. For illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public 18

19 IPOV international equity example: IOPV and NAV for international equity ETFs The IOPV for an international equity-based ETF often deviates from the bid/ask of the ETF in the secondary market due to the differences in trading times. The screenshots on the right show the IOPV and the bid/ask spread for Invesco FTSE RAFI Emerging Markets ETF (PHX) of $24.86 and $24.93/$24.95, respectively. PXH is comprised of stocks listed in various emerging markets. Both screenshots were captured on Jan. 24, 2018, a day where emerging markets were up on the day. The IOPV, in this example, is reflective of the last print of each of the securities in the basket. Despite the fact that the securities may have been closed for some time, the close price of that security is still used for IOPV calculation purposes. The IOPV price will not reflect any market movement that may have occurred after the corresponding component closings. The bid/ask spread of PXH in the secondary market, despite its appearance of being offered at a discount to IOPV, actually represents the most accurate fair valuation for the ETF. In this example, the ETF is acting as a price discovery vehicle for the basket given the various correlated instruments that are available to the liquidity providing community. Should one liquidity provider misprice the ETF, another liquidity provider may capitalize on this mispricing, trading the ETF until no additional arbitrage profit exists. Although the IOPV is often a reliable indication of fair value for ETFs comprised of domestic equities, it is important to understand the limitations of the IOPV for ETFs comprised of international components. We encourage you to contact us to gauge fair value in these circumstances. For Institutional Investor Use Only Not For Use with the Public 19

20 PXH IOPV PXH bid/ask Source: Bloomberg L.P. For illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public 20

21 IPOV and NAV fixed income example: Fixed Income IOPV and NAV Unlike equity ETFs, with fixed income ETFs, the IOPV calculation may not be derived from the last price of all the underlying bonds in the basket. The IOPV calculation may use different swap or futures curves or bond valuation methods to determine an intraday value, which may cause the IOPV price to deviate from the ETF s trading price. As with equity-based ETFs, if a fixed income ETF is mispriced according to a liquidity provider s pricing model because of the arbitrage mechanism, that liquidity provider will trade the mispricing until the ETF falls back in line with fair value. With Invesco fixed income ETFs, it is important to bear in mind that the calculation of the NAV is based on the midpoint between the bid and the offer of the bonds that comprise the ETF based on the bond close (typically 3 p.m. ET). If sentiment after bond close but before the ETF close (4 p.m. ET) is positive for bond prices, the ETF will appear to close at a premium to NAV on its 4 p.m. close; if there is negative sentiment, the ETF will appear to close at a discount. Balance of flows in and out of a fixed income ETF is a major factor in determining where the ETF will trade relative to its underlying basket of fixed income securities. If there is skewed demand to purchase (i.e., more buying than selling), most likely, liquidity providers will have to create shares of the ETF, which will involve them transacting in the underlying securities by purchasing the bonds OTC at the bond dealers offer. This would cause the ETF to trade at a perceived premium to the mid-marked value of the underlying bonds. If demand is skewed to sell the ETF, liquidity providers may have to redeem the ETF, selling out of underlying bonds OTC at the dealers bid. This would cause the ETF to trade at a perceived discount to the mid-marked value of the underlying bonds. If however, inflows and outflows are balanced with activity both on the bid and offer, liquidity providers will be able to match up customer flow and avoid the need to transact in the underlying bonds, potentially reducing investor transaction costs. This balanced flow may also help reduce any premium or discount the ETF may experience to the mid-marked value of the underlying bonds. As shown on the next page, during the first two months of 2017, Invesco Senior Loan ETF (BKLN) traded at an average premium to NAV of 14 basis points. Over that period, BKLN, was in a consistent series of creations, with shares outstanding increasing 12%. As new shares were created, the underlying loans were sourced on or near the offer, thus the fund was priced at a premium to NAV. For Institutional Investor Use Only Not For Use with the Public 21

22 BKLN average premium NAV During the fourth quarter of 2017, as BKLN began to experience selling pressure, the fund entered a series of redemptions as shares outstanding dropped 9%. As shown below, throughout this time period BKLN traded at an average discount to NAV of approximately 9 bps. BKLN average discount to NAV Source: Bloomberg L.P. For illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public 22

23 Contact us ETF overview ETF structure NAV and IOPV ETF pricing Components of ETF liquidity Secondary markets Alternative methods of execution Shorting ETFs Important information

24 ETF pricing ETF pricing is not based on supply and demand, as is the case for an individual security. Rather, due to arbitrage between the ETF and the underlying holdings, the ETF should trade close to the value of its underlying basket plus fees. What is arbitrage? Arbitrage is the practice of simultaneously buying and selling similar or identical instruments for a riskless profit. Arbitrage is an integral facet to the ETF structure because liquidity providers set their pricing around the cost to buy or sell an ETF s underlying basket plus carry, transaction and other costs. In a US equity-based ETF, the liquidity provider may set their bid price lower than the price derived from the bids of all the constituents in the basket and set their offer price higher than the derived ETF price based on all of the offers of the constituents in the basket. If an investor sells at the liquidity providers bid price or buys at their offer price, the liquidity provider may simultaneously hedge their ETF trade with a trade in the underlying basket. The arbitrage mechanism Market neutral Short sell ETF Liquidity provider Basket of securities ETF shares Client Potential creation of ETF Shares For illustrative purposes only. Arbitrage: The process of buying or selling similar or identical instruments to realize a riskless profit. For Institutional Investor Use Only Not For Use with the Public 24

25 If a liquidity provider s displayed: Bid is too high - Other market participants will sell the ETF and simultaneously purchase the underlying basket, capturing an arbitrage profit from the mispricing. Offer is too low - Other market participants may purchase the ETF and short the underlying constituents. Arbitrage Basket vs. ETF Short ETF (higher cost) Long ETF basket (lower cost) For illustrative purposes only. This arbitrage process may continue until the ETF price is driven back in line with the value of the underlying securities. For ETFs with underlying baskets with limited liquidity or ETFs with underlying baskets that trade during different hours than the ETF, liquidity providers often hedge ETF positions with instruments other than the entire underlying basket. This will be discussed in more detail in the next section: Components of ETF liquidity. For Institutional Investor Use Only Not For Use with the Public 25

26 Contact us ETF overview ETF structure NAV and IOPV ETF pricing Components of ETF liquidity Secondary markets Alternative methods of execution Shorting ETFs Important information

27 Components of ETF liquidity From a liquidity provider s perspective, an ideal situation is to have traded ETF shares, lock in a spread and finish the day with a flat or market neutral position. In order to do so, the liquidity provider may use one of three different hedges: The underlying basket constituents (as mentioned in ETF Pricing and the Arbitrage Mechanism), Related derivatives, and/or Other highly correlated instruments. If a highly correlated hedge can be constructed, liquidity providers can be active in providing tight, liquid markets in an ETF. The average daily volume (ADV) of the ETF itself can aid in liquidity helping natural buyers and sellers find one another in the secondary market and avoiding the need to create or redeem shares. However, ADV only begins to tell the story of the true liquidity that can be sourced for a particular ETF. The underlying basket and implied liquidity One hedge the liquidity provider can obtain is the underlying ETF basket, allowing arbitrage profit to instantaneously be captured. With this in mind, when determining the liquidity of a particular ETF, it is important to examine the liquidity of the underlying constituents of the ETF to gauge the number of ETF shares that may be traded without significantly impacting the price of the underlying components. Liquidity providers will likely hold their long/ short position until they are able to either zero out the position with a creation/redemption to the issuer (primary market liquidity), or flatten their position in the secondary market (secondary liquidity). To assess how liquid the underlying basket is, an investor may look at the implied liquidity of the ETF as a general indication. Implied liquidity is a statistical measurement that provides investors an indication of how many shares of the ETF can potentially be traded based on the liquidity of the underlying constituents. It is derived by calculating a percentage of the ADV of the least liquid constituent in the basket that the ETF tracks. The implied liquidity figure allows an investor to determine the quantity of ETF shares that may be traded, while still remaining under 25% of the ADV in all underlying constituents of the basket. 7 The greater the trading volume of the underlying basket, the less the potential impact a sizable ETF trade may have. Implied liquidity = (30 day ADV x 25%) shares per creation unit (least liquid constituent) x Creation size Average Daily Volume (ADV): The average number of shares traded over a specified amount of time. ADV= total shares traded divided by number of days. Implied liquidity: A daily measure of how many shares of the ETF can potentially be traded based on the underlying basket constituents. This measure is derived by taking a percentage of the ADV of the least liquid constituent in the basket that the ETF tracks. 7 The implied liquidity function on a Bloomberg terminal uses 25% as the default. For Institutional Investor Use Only Not For Use with the Public 27

28 ETF liquidity beyond the basket In the instance that a very large position is being established which may represent a high percentage of volume in the underlying constituents and thus be impactful, a liquidity provider may use a completion basket as a hedge. Completion baskets use many, but not all, of the constituents of the ETF basket, thus typically exhibiting a high correlation to the ETF. The liquidity provider may then work into the more impactful trades over time seeking to minimize the impact. Related derivatives Related derivatives, such as options, futures and swaps are common instruments used by liquidity providers to hedge their market risk and add another layer of liquidity to the ETF. These derivatives may often provide a quick, highly correlated hedge for an ETF trade. The liquidity provider may choose to implement a derivative hedge when the corresponding basket is closed or when it is more time efficient to trade one derivative as opposed to the entire basket. Unlike using the ETF s underlying basket, related derivatives may not be a perfect hedge and therefore may involve more risk for the liquidity provider. This increased risk may result in a potentially wider, less efficient market. To help reduce this risk, liquidity providers may seek derivatives with the highest correlation and then work out of the derivative hedge and into the basket over time. Other highly correlated instruments Highly correlated products, such as other ETFs, CEFs and UITs, allow liquidity providers to effectively hedge by trading one instrument against another. This is a very common practice when trading in US-listed ETFs with international constituents, where the ETF basket is closed while the ETF is actively trading. For example, if the liquidity provider sells an emerging market ETF and cannot source the basket at the time of the trade, they may use another highly correlated emerging market ETF to remain as close to market neutral as possible. Market neutral: A hedged position that should not introduce positive or negative P&L or change in value due to market movement. For Institutional Investor Use Only Not For Use with the Public 28

29 See the liquidity case studies on our website or contact us for help assessing the liquidity of an ETF. Secondary market activity in the ETF In addition to the liquidity that can be derived from the underlying holdings, the ETF s average daily volume in the secondary market can add an additional layer of liquidity. As natural buyers and sellers enter the market for the ETF, order flow can cross in the secondary market, providing an additional layer of liquidity. For an ETF, such as Invesco QQQ, which trades approximately 30 million shares per day, 8 large share quantities may be able to be traded without relying on market liquidity. Together, all of the components discussed contribute to the ETF s liquidity. A firm knowledge of the components of ETF liquidity may help alleviate fears of trading lower volume ETFs that do not appear to have significant depth in the secondary market. Components of liquidity Underlying basket and implied liquidity Secondary market liquidity ETF liquidity Related derivatives Other highly correlated instruments For illustrative purposes only. 8 Source: Bloomberg L.P., as of Jan. 25, 2018 For Institutional Investor Use Only Not For Use with the Public 29

30 Date: July 21, 2014 Shares: 7,096, day ADV: 1,780,000 shares Day range: $ $38.28 Components of ETF liquidity Example SPLV We see an example of how liquidity is sourced in Invesco S&P 500 Low Volatility ETF (SPLV). On July 21, 2014, a 7,096,476 share block was printed near the screen offer of $ Just prior to this trade, the secondary market showed available liquidity of only 3,800 shares. The trade occurred during US trading hours when both the ETF and its underlying basket could be sourced. With 30-day ADV of 1,780,000 shares, a print of almost four times that amount underscores that additional ETF liquidity may be derived from the underlying basket. While a trade of this size may appear large relative to SPLV s ADV, it is only a small portion of the liquidity that can be derived based on the underlying holding. SPLV shows an implied liquidity of over 16.9 million shares. Components of ETF liquidity (SPLV) Source: Bloomberg L.P., for illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public 30

31 Contact us ETF overview ETF structure NAV and IOPV ETF pricing Components of ETF liquidity Secondary markets Alternative methods of execution Shorting ETFs Important information

32 Secondary markets Like equities, ETF trades are executed on US exchanges at the National Best Bid or Offer (NBBO), so it s important to understand the advantages/disadvantages of various order types. Types of orders Definition Advantages Disadvantages Market An order placed for a particular ETF, which will be executed immediately at the best available price. A market order prioritizes speed of execution over the price at which the order is executed. Quick execution. Order will be filled at best available bid/ offer, which may or may not be favorable. Stop An order to buy or sell at the current market price once the ETF has traded at or through the specified price. Allows automatic entry or exit once a specific price level is hit. Order may be filled at a much higher or much lower price than the ETF s fair value based on the underlying basket s securities. Limit An order to buy or sell an ETF at a set price or better. Limit orders do not guarantee an order will be filled. If filled, the order will be executed at the specified limit price or better. No assurance of order execution. Stop Limit An order to buy or sell an ETF at the specified limit price or better once it has traded at or through the specified stop price. Designed as an automatic trigger for an order entry or exit once a certain price level has been achieved. If filled, the order will only be executed at a specified limit or better. Order may get filled at a much higher or much lower price than the ETF s fair value based on the underlying basket s securities. Marketable Limit A limit order entered at or above the best offer (to purchase) or at or below the best bid (to sell). There may be a higher probability of execution than a traditional limit order placed inside the NBBO. Increases chances of execution. If filled, the order will be executed at the specified limit price or better. No assurance of order execution. While a market order may be useful for a high urgency trade, it may leave an investor exposed to an unfavorable execution price. It may be best to avoid market orders for thinly traded ETFs and use a limit order instead. If a market order exceeds the size of the posted liquidity across all exchanges, the order will continue to be filled with any available posted liquidity until the order is completely filled. National Best Bid/Best Offer (NBBO): The best (lowest) available ask price and the best (highest) available bid price posted on exchanges. For Institutional Investor Use Only Not For Use with the Public 32

33 Case study Let s take a look at the execution of both a market order and a marketable limit order to see how they differ. For these examples, we ll assume the order book for ABC is as follows: Bid Ask Shares Price Price Shares 6,000 $25.21 $ ,000 20,000 $24.90 $ ,000 Example 1 - Market order: If a market order to buy 25,000 shares is routed to the exchange, the order will give priority to the speed of execution and will be filled at the current best price available. In this case, the investor will receive the first 10,000 shares at a price of $ If no other liquidity is available, they ll receive the remaining 15,000 shares at $26.01, resulting in an average execution price of $ Example 2 - Marketable limit order: A limit order puts the execution priority on price and ensures that if an order is filled, it is executed at the specified price or better. Depending on the objectives of the investor, entering a buy order at a cent or two above the current offer or entering a sell order at a cent or two below the current bid (a marketable limit order) may be an alternative to entering a market order. So, for this example, assuming the marketable limit order for 25,000 shares is filled at $25.26 (one cent above the ask price of $25.25), the investor has protected the order from deviation in the fill price by allowing the liquidity providers time to refresh their quote and offer additional shares in the secondary market. Stop orders Stop orders are designed to limit an investor s loss on a position, but they do not guarantee a specific price. Because market orders emphasize speed above price execution, a triggered stop order that becomes a market order can lead to an execution price which may not reflect the value of the ETF s underlying securities. ETF investors should clearly understand this potential consequence, especially in times of extreme market disruptions, such as Aug. 24, 2015, when extreme market volatility left investors susceptible to wider bid/ask spreads and unpredictable order execution. When evaluating stop orders, it s important to remember that an ETF is simply a wrapper holding an underlying basket of securities. Market makers who stream ETF quotes rely on this basket of securities to accurately price ETFs. When the underlying securities exhibit high volatility and wide bid/ask spreads, the ETF spread may also widen potentially triggering a stop order. One alternative to using a stop or stop-limit order may be to set up a system alert when the price of the ETF falls below a specific trigger price, and then evaluate the situation accordingly. In summary, depending of the size of your order relative the average daily volume of the ETF, it s worth careful consideration of all five types of orders when placing your trade. The Capital Markets team can assist with any questions about ETF trading. For Institutional Investor Use Only Not For Use with the Public 33

34 Contact us ETF overview ETF structure NAV and IOPV ETF pricing Components of ETF liquidity Secondary markets Alternative methods of execution Shorting ETFs Important information

35 Alternative methods of execution There are often single ETF prints that are much larger than the ADV of an ETF. If these prints are not executed directly on secondary exchanges via market or limit orders, there are typically four additional ways the order is handled: Risk market Average price trade Derivatively priced trade Direct creation/redemption through an AP Risk market When an ETF order is larger than the liquidity posted in the secondary market, a client may seek a risk market. While typically used for larger orders, this can be done for any size trade. A risk market is a quote sized up to the specifications of the client. Risk trades are principal transactions,as the liquidity provider commits internal capital to trade on behalf of the firm against the client. With this process, a liquidity provider provides the customer with a bid and offer based on its own pricing model. (See the chart below.) The quote is often two-sided, meaning it has the best bid and offer that the liquidity provider is willing to trade at, so that the client does not need to give up the direction of their order before trading. If the liquidity provider s quote is higher than the current offer or lower than the current bid in the secondary market, the liquidity provider must first sweep the order book up to the quoted price which can improve client execution. Obtaining a risk market Liquidity provider 2-sided quote Call A Client 2-sided quote Call 2-sided quote Call B C For illustrative purposes only. Client trades at best price. A risk market may allow the client to know the exact price for the full block before executing. However, because the potential risk of slippage while implementing a hedge rests on the liquidity provider, a risk premium may be built into the quote provided. Initially, a risk trade is not directly posted on the exchange, but rather done over-the-counter (OTC) and is then printed to the consolidated tape. Slippage: Refers to the risk of market movements from the time a trade in initiated to when it is actually executed. Risk premium: An indirect cost paid by an investor to a liquidity provider as compensation for taking on risk. Risk premiums are expressed in the ETF s quoted price. For Institutional Investor Use Only Not For Use with the Public 35

36 Agency risk market/liquidity aggregator In addition to obtaining a risk market from a liquidity provider in a principal capacity, a client may also use a liquidity aggregator. Unlike a liquidity provider, a liquidity aggregator will not provide a quote based on their internal pricing model, but rather reach out to several liquidity providers to obtain a price for the trade. More recently, clients have been using electronic liquidity aggregation platforms called RFQs (request for quotes). By contacting different liquidity providers, the liquidity aggregator is able to get multiple viewpoints on the ETF and have the liquidity provider network compete for the business. Based on the quotes received, the client can execute their order at the best price offered. It is important to note the aggregator model may add an additional fee. Using a liquidity aggregator Liquidity provider 2-sided quote Call A Call Best quote 2-sided quote Call B Client Aggregator 2-sided quote Call C For illustrative purposes only. An individual liquidity provider may use a different pricing model that implements a highly correlated completion basket or may have inventory in a particular ETF and thus be willing to provide a better bid/offer than the rest of the network. Liquidity aggregator: A party acting in an agency capacity to facilitate order flow between buyers and sellers which often includes aggregating bids and offers from multiple principal traders. RFQ: Request for quote; electronic liquidity aggregator platform. For Institutional Investor Use Only Not For Use with the Public 36

37 The trade below of Invesco S&P Small Cap Low Volatility ETF (XSLV) on July 14, 2015, may have been executed using a risk market. The displayed print shows a 207,450 share block order to purchase XSLV. At the time of the trade, there were only 500 shares offered at $34.15 (200 shares on the bid at $34.13) and yet the full 207,450 share block was printed on the best offer at This print illustrates that sizable liquidity may be accessed efficiently beyond what is posted in the secondary market. Block execution XSLV risk market Source: Bloomberg L.P. For illustrative purposes only. For Institutional Investor Use Only Not For Use with the Public 37

38 Average price trade In addition to sourcing ETF shares in the secondary market, the underlying basket for the ETF can be sourced over a period of time and printed as an average price trade. It is important to note that with an average price trade, the client bears the risk of any market movement while the underlying basket constituents are being sourced on their behalf. In this case, the client pays the average execution price and a commission to the liquidity provider. One common way to accomplish this is to use a simple participation strategy, such as a timeweighted average price (TWAP) or volume-weighted average price (VWAP) of the underlying constituents of the basket. When a TWAP of the underlying securities is performed, a predetermined amount of the ETF s constituents are purchased over a given time frame. For example, if an investor wanted to purchase 10 million shares of a given ETF using a TWAP over a period of five hours, they would systematically buy two million shares of the basket equivalent every hour until the entire 10 million share order was completed. A VWAP of the underlying securities is similar to a TWAP; however, with a VWAP, a set percentage of the underlying securities average volume over the period will be purchased until the entire order is completed. Example of TWAP and VWAP Time Weighted Average Price (TWAP): Buy 100,000 Volume Weighted Average Price (VWAP): ADV=1,000,000 shares, buy 100,000 Time # shares bought Percent of order bought Total Volume # shares bought Volume participation rates 9:00 AM 20,000 20% 11:00 AM 20,000 40% 1:00 PM 20,000 60% 3:00 PM 20,000 80% 250,000 25,000 10% 500,000 25,000 10% 750,000 25,000 10% 1,000,000 25,000 10% 4:00 PM 20, % For illustrative purposes only. Again, the client will pay actual execution costs, along with a commission. In ETFs with lower ADV where the underlying constituents are more easily accessed than shares of the ETF, this method can be used to obtain a price that is close to the fair value of the ETF over the time the underlying basket is sourced. The drawback is that an average-price trade takes time, and thus reflects market movement during the execution period. If a buy order is executed in a rising market, the order may have been executed at a better price using a risk market (actual fill prices are executed at a higher price). On the other hand, if the market were to decline while sourcing, the buy order may be filled at a more favorable price than if a risk market were used. Average price trade: Typically, a liquidity provider will trade the underlying constituents of an ETF basket over a specified time period for the client transaction. Once a representative number of ETF baskets have been traded the client will receive the average ETF price based on that execution (additional brokerage commission may apply). For Institutional Investor Use Only Not For Use with the Public 38