VIX Futures Prices vs. Predictions from a “Simple” Model

Updated: Dec 9th, 2015 | Vance Harwood

It’s been said that we learn more from failures than success. Hopefully the chart below will be an illustration of that. It displays the near real-time prices of VIX futures vs. the predictions of a “simple” model I’ve created.  My intent with the model is not to achieve high accuracy (it won’t) but rather to distinguish between when VIX futures prices are truly unusual, and when they are displaying typical behavior.

 

The yellow dots show the percentage error between my estimate and the actual quotes.

I put simple in quotes above because I recognize that most people would not consider the formulas below simple.  But compared to the typical academic treatment of VIX Futures pricing this is a simple model.

SM-VIX futures pricing

 

The difference between this model and the one I described in the very simple model displayed below is the addition of functionality that addresses VIX jumps and slumps. The VIX itself is quite volatile with daily double-digit percentage changes being relatively common. Typically VIX futures lag these moves by about half (e.g, if VIX moves +10% the VIX futures term structure might shift up 5%).

I modeled this behavior with an exponential moving average of the VIX, using a coefficient of 0.5. This enhancement works well for the longer-dated futures, but shorter-term VIX futures have progressively tighter tracking to the VIX. To address this, I tweaked the jump/slump term, using a natural log function to extinguish the jump/slump lag as the time to expiration approaches zero.

A Very Simple Model

The graphs and descriptions below belong to my very simple model, which does not incorporate the historical patterns of the VIX at all.

 

The percentage errors are shown in yellow organized by expiration date.

The current VIX futures quotes are from Yahoo Finance (e.g., ^VIXnov).  Unfortunately as far as I know they aren’t providing quotes on the new Weekly VIX Futures yet. The chart below shows the model’s predictions for their values.

 

that I’ve created

You can check over at vixcentral.com if you want to get the current values for both traditional monthly and the new Weeklys VIX futures (click on the “VIX Term All” tab).

My estimates are produced using this equation:

VS-VX_FUT version B equation

Where VIX is the current VIX index value, VIX Median is the historic VIX Median value (18.01 for March 2004 through September 2015), and X = days until VIX Future expiration.

For more information on this equation see, “A Very Simple Model for Pricing VIX Futures.”

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How Does TVIX Work?

Updated: Oct 8th, 2015 | Vance Harwood

Exchange Trade Note TVIX and its Exchange Traded Fund cousin UVXY are 2X leveraged funds that track short term volatility.  To have a good understanding of TVIX (full name: VelocityShares Daily 2x VIX Short-Term ETN you need to know how it trades, how its value is established, what it tracks, and how VelocityShares makes money on it.

 

How does TVIX trade? 

  • For the most part TVIX trades like a stock. It can be bought, sold, or sold short anytime the market is open, including pre-market and after-market time periods.  With an average daily volume of 21 million shares its liquidity is excellent and its bid/ask spread is penny.
  • Like a stock, TVIX’s shares can be split or reverse split. If fact, TVIX reverse split 3 times in its first four years of existence. The last reverse split was 10:1 and I’m predicting the next one will be around September 2016 with a 10:1 ratio also.  See this post for more details.
  • Unlike UVXY there are no options available on TVIX.
  • TVIX can be traded in most IRAs / Roth IRAs, although your broker will likely require you to electronically sign a waiver that documents the various risks with this security. Shorting of any security is not allowed in an IRA.

 

How is TVIX’s value established?

  • Unlike stocks, owning TVIX does not give you a share of a corporation.  There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no prospect of ever getting dividends.  Forget about doing fundamental style analysis on TVIX. While you’re at it forget about technical style analysis too, the price of TVIX is not driven by supply and demand—it’s a small tail on the medium sized VIX futures dog, which itself is dominated by SPX options (notional value > $100 billion).
  • According to its prospectus the value of TVIX is closely tied to twice the daily return of the S&P VIX Short-Term Futurestm .
  • The index is maintained by S&P Dow Jones Indices. The theoretical value of TVIX if it were perfectly tracking 2X the daily returns of the short term index is published every 15 seconds as the “intraday indicative” (IV) value.  Yahoo Finance publishes this quote using the ^TVIX-IV ticker.
  • Wholesalers called “Authorized Participants” (APs) will at times intervene in the market if the trading value of TVIX diverges too much from the IV value.  If TVIX is trading enough below the IV value they start buying large blocks of TVIX—which tends to drive the price up, and if it’s trading above they will short TVIX.  The APs have an agreement with Credit Suisse that allows them to do these restorative maneuvers at a profit, so they are highly motivated to keep TVIX’s tracking in good shape.

 

What does TVIX track?

  • Ideally TVIX would exactly track the CBOE’s VIX® index—the market’s de facto volatility indicator.  However since there are no investments available that directly track the VIX VelocityShares chose to track the next best choice: VIX futures.
  • VIX Futures are not as volatile as the VIX itself; solutions (e.g., like Barclays’ VXX) that hold unleveraged positions in VIX futures typically only move about 55% as much as the VIX. This shortfall leaves volatility junkies clamoring for more—hence the 2X leveraged TVIX and UVXY.
  • TVIX attempts to track twice the daily percentage moves of the S&P VIX Short-Term Futurestm  index (minus investor fees).  This index manages a hypothetical portfolio of the two nearest to expiration VIX futures contracts.  Every day the index specifies a new mix of VIX futures in that portfolio.  For more information on how the index itself works see this post or the VXX prospectus.
  • TVIX’s tracking to its target index is not as good as UVXY.  I’ll get into the details of why later in the post, but on average you pay a premium of almost 2% for TVIX shares relative to the index it tracks, compared to a premium of 0.25% for UVXY.   For a security as volatile as TVIX this is not an especially big deal, but worth knowing.
  • If you want to understand how 2X leveraged funds work in detail you should read this post, but in brief you should know that the 2X leverage only applies to daily percentage returns, not longer term returns. With a leveraged fund longer term results depend on the volatility of the market and general trends.  In TVIX’s case these factors usually (but not always) conspire to dramatically drag down its price when held for more than a few days.
  • The leverage process isn’t the only drag on TVIX’s price. The VIX futures used as the underlying carry their own set of problems. The worst being horrific value decay over time.  Most days both sets of VIX futures that TVIX tracks drift lower relative to the VIX—dragging down TVIX’s underling non-leveraged index at the average rate of 7.5% per month (60% per year).  This drag is called roll or contango loss.
  • The combination of losses due to the 2X structure and contango add up to typical TVIX losses of 15% per month (85% per year). This is not a buy and hold investment.
  • On the other hand, TVIX does a decent job of matching the short term percentage moves of the VIX. The chart below shows historical correlations with the linear best-fit approximation showing TVIX’s moves to be about 93% of the VIX’s.    The data from before TVIX’s inception on October 3, 2011 comes from my simulation of TVIX based on the underlying VIX futures.

TVIX-per-regression

  • Most people buy TVIX as a contrarian investment, expecting it to go up when the equities market goes down.  It does a respectable job of this with the median TVIX’s percentage move being -4.8 times the S&P 500’s percentage move. However 18% of the time TVIX has moved in the same direction as the S&P 500.  So please don’t say that TVIX is broken when it doesn’t happen to move the way you expect.
  • The distribution of TVIX % moves relative to the S&P 500 is shown below:

TVIX ratio histo

  • With erratic S&P 500 tracking and heavy price erosion over time, owning TVIX is usually a poor investment. In fact, even the provider’s marketers who you’d expect to figure out a positive spin, state that “The long term expected value of your ETNs is zero.”  Unless your timing is especially good you will lose money.

 

How do Credit Suisse and VelocityShares make money on TVIX?

  • Credit Suisse, TVIX’s issuer, collects a daily investor fee on TVIX’s assets—on an annualized basis it’s 1.65% per year.  With current assets of around $250 million this fee generates approximately $4 million per year.  That should be enough to cover TVIX costs and be profitable, however I suspect their business model includes revenue from more than just the investor fee.
  • VelocityShares (now owned by Janis Capital Group) – gets a portion of the investor fee for its marketing and branding efforts.
  • Unlike an ETF, TVIX’s Exchange Traded Note structure does not require Credit Suisse to specify what they are doing with the cash it receives for creating shares.  The note is carried as senior debt on their balance sheet but they don’t pay out any interest on this debt.  Instead they promise to redeem shares that the APs return to them based on the value of its index—an index that’s headed for zero.
  • To fully hedge their liabilities Credit could hold the appropriate number of VIX futures contracts, but they almost certainly don’t because there are cheaper ways (e.g., swaps) to minimize their risks.  Given TVIX’s inexorable journey towards zero it would be tempting to assume some risk and not fully hedge their TVIX position, but I doubt Credit Suisse has a corporate culture that would support that. Instead I suspect they put fund assets not needed for hedging to work earning interest on relatively safe investments like collateralized repurchase agreements.  Earning even an extra percent or two annually on $250 million is real money.

February through March 2012 —When TVIX was not working

  • In February 2012 TVIX’s assets were growing rapidly, climbing several hundred million in a few days to reach $691 million. Normally this would be viewed as a very good thing by an ETN’s issuer, but Credit Suisse was not happy.  With a daily resetting fund like TVIX positions need to be rebalanced daily, and with a 2X leveraged fund the positions adjustments needed are equal to the day’s percentage move times the asset value of the fund.  So if TVIX was to move +30% in a day, not unprecedented, and the assets were at $690 million, then an additional $207 million in hedging securities would be need to be purchased that day.  We don’t know the reason, but likely because of the costs of doing that hedging or the risks of a swap’s counterparty defaulting Credit Suisse decided to stop creating new TVIX shares on February 22, 2012.  This prevented the assets of the fund from growing any larger.
  • You might think that limiting the number of shares in an ETN would be a good thing for the shareholders—if shares are scarce they might become more valuable. But for exchange traded products this is a very bad thing.   The share creation mechanism is essential to the process that keeps the fund closely tracking its underlying index.  Specifically if TVIX’s value gets too high relative to its index the authorized participants will normally short TVIX and hedge that position with VIX futures related securities to lock in a risk free profit.  They will continue to short sell, driving down TVIX’s price until the gap between TVIX and the index is too small for this arbitrage transaction to be profitable.
  • Short selling requires that there be shares available to be borrowed, and with Credit Suisse no longer willing to create new shares the supply of borrowable shares dried up completely. As a result TVIX’s share value became untethered from its index and by the end of March was trading at a 90% premium to the index.  In market cap terms there was around $277 million of bogus value in TVIX.
  • In late March 2012 Credit Suisse resumed share creation and the TVIX premium evaporated instantaneously—leaving a lot of stunned and poorer shareholders. Credit Suisse’s solution to their problem was to lay more of the risk on the authorized participants, requiring them to provide the necessary securities before they would create shares.  The extra cost of doing this is reflected in the premium (often around 1% or 2%) in TVIX’s price over its index.

 

TVIX—destroyer of wealth

  • According to ETF.com’s ETF Fund Flows tool, TVIX’s net inflows have been around $1.8 billion since its inception in 2010.  It’s currently worth $220 million, so VelocityShares has facilitated the destruction of over one and a half billion dollars of customer money—so far.  I’m confident this overall destruction will continue.

TVIX’s race to zero attracts a lot of short sellers.  That strategy works most of the time, but if your plan is to ride out any volatility along the way be prepare to handle a 4X or more spike in TVIX”s value.  Most people are unequipped both financially and emotionally to handle this sort of reversal.

TVIX has a proven record as a cash incinerator, but its occasional upward spikes continue to attract speculators hoping to profit from the anguish of the general market.  A few traders with impeccable timing or good luck will make good money going long on TVIX.  Most will lose money.

TVIX split adj price 2004

 

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The SEC’s Circuit Breakers for ETFs Short Out

Updated: Aug 27th, 2015 | Vance Harwood

In the aftermath of the 2010 Flash Crash the SEC investigated ways to prevent the widespread disruption of prices that led to trades at absurd levels.  One of the outcomes was the creation of single stock circuit breakers across the entire market (SEC document).  These breakers are designed to halt trading at specific points to allow markets to stabilize before restarting.  Bigger drops triggered longer waits between restarts.

On Monday, August 24th we saw a test of these circuit breakers for Exchange Traded Funds (ETFs). They failed miserably.

Things weren’t as bad as the 2010 Flash Crash, but that’s faint praise indeed, and it wasn’t just small, low liquidity funds that suffered.

Guggenheim’s S&P 500 Equal Weight ETF (RSP) has $9.5 billion in assets, yet look at what happened on the 24th.

RSP

A 38% drawdown from its opening value.

David Nadig from ETF.com does an excellent detailed analysis of what happened with RSP in Understanding ETF Flash Crashes, including the action of the SEC mandated circuit breakers that “moderated” the crash.

The bottom line is that the essential 2nd tier of liquidity providers for this ETF, the market makers / authorized participates were on the sidelines during this flash crash.

The first tier of liquidity is provided by the people/ institutions that want to buy or sell the ETF itself.  With an ETF there is a second level of liquidity providers that steps in if the trading price of the fund starts deviating significantly from the prices of the securities that underlie the fund.  These providers earn risk free profits by buying the underlying securities when relatively underpriced while simultaneously shorting the ETF or selling the underlying short when underpriced by the ETF and buying the ETF shares.

This action by the 2nd tier participants typically keeps ETFs trading close to their intraday indicative value (IV) — which is an index provided by all ETFs that computes the value of the underlying assets of the fund every 15 seconds. The chart below shows the IV values of RSP compared to its traded values.

RSP-Vs RSP-IV-2

The value of RSP’s underlying assets, its IV price, only went down 3.1% during the crash.

So the 2nd level liquidity providers were missing in action.  In fairness the IV values were probably not an accurate estimate of the prices of the underlying securities at that point—their bid / ask quotes were much wider apart than normal.  But even taking that into account the drop in value of RSP’s assets was nowhere near 38%.

Given the chaotic nature of the market I don’t blame the market makers from stepping back until things settled down a bit.  This report from iShares adds a considerable amount of detail on what happened.

Clearly the SEC did not foresee this situation.  The circuit breakers algorithms naively assumed that the listed quotes were representative of the value of the fund’s asset during chaotic times.

Clearly the SEC’s circuit breakers are a work in progress and aren’t working acceptably.  I think the next step should be to incorporate the IV value of the fund into the circuit breaker calculations.  Trading halts should be continued when the tracking error between the IV value and the quoted price exceeds some multiple of the normal tracking error, maybe 5X.  This would protect investors from being sold out at obviously bogus values.

 

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Trading Low Volume Exchange Traded Products   

Updated: Aug 21st, 2015 | Vance Harwood

Many of the 1600+ Exchange Traded Products (ETPs) on the market are low volume, low asset offerings that either implement failed strategies or have bigger, higher volume competitors.  However some low volume ETPs offer unique opportunities you won’t want to wait for.

I’ve organized the special handling required for low volume funds into these categories:

  • Alternatives
  • Before you buy
  • When you buy
  • While you’re holding
  • When you sell

The liquidity of low volume ETPs is a big topic of its own which I discuss in Determining the Liquidity of Low Volume ETPs

 

Choosing an ETP—are there alternatives?

Before you trade a low volume ETP you should search for alternatives.  The biggest fund in a given strategy segment will usually have the narrowest bid / ask spreads and the best ability to handle large trades without shifting significantly in value. When comparing bid/ask spreads between ETPs it’s useful to convert them into percentages of the trading price (e.g., a 7 cent spread for a $25 ETP is 0.28%).

Some people prefer Exchange Traded Funds (ETFs) over Exchange Traded Notes (ETN) for the equivalent strategy because the assets underlying the ETF are held directly by the fund.  Whereas ETNs just give you a promise from the issuer to make good on redemptions, much like a bond, and you typically have no visibility into how the issuer is hedging their positions.  Since ETN issuers are typically big banks with very good credit ratings I don’t put much weight in this distinction.  See “Credit Risk and Exchange Traded Notes” for more detail on this subject.

Two other possible selection criteria are availability of options on the fund, and tax considerations.  Some funds require a K-1 form to be submitted for taxable accounts rather than the typical 1099 treatment. That’s usually not a big deal, but something to be aware of.

Finally, fees are worth a look as a tie-breaker.  However if you’re interested in a low volume ETP you’re probably looking for gains that are large compared to the differences in in fees.

 

Before you buy

Once you’ve selected a low volume ETP you’re still not ready to trade.  Some due diligence on the day-to-day price behavior of the fund is called for.  There are three key factors:  bid /ask spreads, intraday value, and market depth.

The difference or spread between the price for you to sell (bid) and the price to buy (ask) for a low volume ETP is usually significantly more than the penny typical for high volume ETPs.  If you have trouble remembering if it is the bid or the ask that is pertinent for your trade just use the price that’s worse for you—that rule always works.   The spread is essentially another fee that you pay every time you go in and out of a fund; if the spread is wide its costs can be comparable to the annual fee.

Monitor the spreads over the course of a couple days and at different times.  Many low volume ETPs seem to need their morning cup of coffee before they reach their normal ranges, so give particular attention to the spreads soon after the market open.  Some authors suggest avoiding trades right before close, but I’ve not seen that be a problem. Get a feel for the normal spread of the ETP— that will be important when you are ready to make a trade.

The intraday value (IV) or intraday Net Asset Value (iNAV), detailed here, is the near real time calculation of the index that the fund tracks, typically updated every 15 seconds.  An IV value between the bid / ask prices gets a green light.  When outside that range it indicates one or more of the following:

  • Liquidity challenges with the underlying  (e.g., Junk Bonds)
  • Difficulties valuing securities on a real time basis (e.g., underlying markets are closed)
  • Extenuating circumstances (e.g., government restrictions / political crisis)
  • The fund might not be working well, see If you think your ETP is broken for details.

These factors aren’t necessarily show stoppers, but they warrant additional investigation.

It’s also a good idea to check the market depth of the fund.  You can do this by looking at the level 2 quotes.  Not only can you see how many shares are being offered at the current NBBO (National Best Bid and Offer) but you can also see how much public liquidity there is at prices inferior to the current best bids and offers.  This post gives more information on interpreting those quotes.  Remember these quotes only report public liquidity— for ETPs there are typically many more shares available near the bid / ask prices that are hidden from view.

 

When you buy—if today is the day

When you have decided to buy you need to make another decision—at what price?  Never use a market order with low volume ETPs, always use a limit order—otherwise you’re just asking to be ripped off.  With a limit order you need to pick a price you are willing to pay and no more, otherwise no trade.  You should only trade an ETP when it is behaving normally.  Put your trade on hold if there’s an abnormally wide spread, unusual IV quote compared to the bid/ask or unusually slim market depth.

If you’ve determined your ETP has good liquidity, and your order isn’t more than a few thousand shares you can be reasonably confident your order will complete at the current ask price.  Market makers will often only officially commit a small number of shares (e.g., 100s) for the current best asking price so unless your order is small you will likely see a series of partial fills that might even stall for a while before your order completes.  The initial action is very fast—clearly computer driven.

When you’ve exhausted the immediate liquidity at the limit price and your order has not been completely filled you will often see a significant pause before any more transactions occur.  I doubt there are any humans involved at this point, but experientially it feels like the other side is considering your order.  Perhaps there are automated queries going to various dark pools soliciting interest—or maybe the computers are just letting you sweat.

If your order doesn’t complete immediately you will see the ask price jump up, increasing the spread beyond its typical levels.   You’ve sucked up the public liquidity displayed at the old ask price; you’re now seeing  the new, higher price the market makers are asking for while they consider your order.

The market will not hold still during this time.  If it moves in your favor your order will complete, but Murphy would say that it will move against you.  If it moves enough, your order won’t complete and you’re left with an incomplete order.  This is not a disaster, you can replace your order (and pay another commission) with a new price that is more likely to complete.  You’re probably still better off than if you had used a market order.

If the market runs away from you when you’ve had a partial fill it’s very tempting to chase it, it’s very frustrating to be that close to a profitable purchase and miss out, but remember that markets fluctuate, and that it’s unlikely you’ve missed the last time the security will trade at that price.

You can try to shave a few pennies off the ask price by offering a price between the bid and ask.  If nothing happens you’ve lost nothing (unless the market moves against you), if you get a fill, or a partial fill you’ve saved some money.

If you order is large from a dollar amount standpoint you should get some help to move your order.  It’s not a good idea for you to break up your order into smaller pieces in hopes of not significantly moving the price.  High frequency traders are very good at sniffing out attempts to do this.  For specifics on getting professional help moving large orders see “How to Trade ETFs Without Getting Fleeced”.

An abnormally narrow spread suggests that someone other than a market maker is trying to beat the spread, offering a trade inside the bid / ask.  If you’re tempted to take this trade check the level 2 quotes to see if your order size is greater than or equal to the size of your trade.  If your order size exceed the listed liquidity you will likely experience a partial fill—not a big deal, but ultimately it might cost you some extra commissions.

 

While you’re holding

Unfortunately low volume ETPs are very susceptible to flash crashes.  One sloppy trader using a large market order can clean out the publically available liquidity in a few milliseconds, often dropping the bid price multiple percentage points.  A market order is required to execute immediately so most hidden sources of liquidity can’t come into play.

General market disruption, “fat finger” trades, and exchange software problems can also glitch ETP prices.

These crashes often are over before a human can even get involved.   The chart below shows how the VXX volatility ETN spiked from +4% to –3% over the course of 10 seconds.

Nanex-vxx-apr15-Futures

 

Because of flash crashes it’s a bad idea to have any sort of standing sell orders or trailing stops in place.  A traditional stop loss order will convert into a market order as soon as the stop price is breached—automatically turning you into a sloppy trader.  Stop loss limit orders are better because they put a lower limit on the price you will sell at, however they will often execute on the recovery side of the flash crash, dumping you out of your position right before the security goes on to regain its pre-crash value.

Eschew automated orders.  Monitor things manually or setup email / text alerts to keep informed.

 

When you sell

 The process for selling is very similar to buying.  Make sure the ETP is trading normally with reasonable bid / ask prices located close to the IV price.  As always with low volume securities limit orders are a must.

 

Conclusion

Low volume ETPs can be very profitable, but must be treated with care.  I frequently see trades on these funds where the investors leave significant money on the table—or more accurately in the market maker’s pocket.   Pay attention and don’t be a chump.

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Evaluating Liquidity of Low Volume Exchange Traded Funds 

Updated: Aug 1st, 2015 | Vance Harwood

It’s disconcerting when the Exchange Traded Fund (ETF) you’re interested in has low trading volumes.  Days can go by with no volume at all.  If it was a small cap stock you wouldn’t consider buying it.  But low volume in itself shouldn’t prevent you from considering an ETF—some have the liquidity of a large-cap stock.

 

ETF Liquidity

Unlike stocks, ETFs have two levels of liquidity.  The first level is the same as a stock—the pool of people / institutions that hold, or are short the security.  The second level of liquidity is the domain of institutions.  They monitor the difference between the ETF’s trading price and the price of the underlying securities.  If that gap gets big enough they will buy or sell the ETF as appropriate and trade an offsetting transaction in the underlying.

For example, let’s say there was a low volume ETF that tracks Apple, Amazon, and Google—I’ll call it AAG, which holds one third of its assets in each stock and rebalances at the end of each day.  During the day you’d expect AAG’s intraday value to be the market prices of AAPL, AMZN, and GOOG times the number shares it’s holding in each.

But what if AAG is trading lower than its asset value?   If you can buy AAG at 55.03, and it has 200,000 shares outstanding the market is valuing the fund at $11,006,000, but what if you could sell AAG’s stock holdings for $11,050,000 –a 0.5% premium?

The second tier liquidity providers know exactly what to do; they buy undervalued shares of AGG, and short the appropriate number of Apple, Amazon, and Google shares to lock in their profit.  At day’s end they go to AAG’s issuer and sell back (redeem) the AAG shares they bought in exchange for shares of AAPL, AMZN, and GOOG. These ratios are fixed for the day so they get exactly the number of shares they need to cover their short positions.  They’ve just made 0.5% on their invested capital with zero risk.  It doesn’t matter what happens to AAG, AAPL, AMZN, and GOOG’s prices after their trade executions—their position is perfectly hedged.  This is an example of riskless arbitrage.

So how do the transactions of the 2nd tier providers (called Authorized Participants, or APs) impact AAG’s price?  Well, if AAG is underpriced they are buying it, driving up the price, and if it is overpriced they are selling AAG—exactly the actions that are needed to bring AAG’s value closer to its ideal level.   Because these transactions are riskless to the APs they are happy to continue them until the price difference between the market and the ideal level becomes too small to be profitable given transaction costs, bid/ask spreads, etc.

In the case of AAG the liquidity provided by the APs makes AAG no riskier for the investor than owning Apple, Amazon, and Google.  You can buy or sell large quantities of AAG without impacting its price.

If the underlying securities of an ETF are liquid then the ETF itself will be liquid too.

On the other hand, the liquidity picture for an ETF that tracks small cap Chinese stocks (e.g., ECNS) is significantly different.  The underlying stocks aren’t even trading when the USA markets are open because there’s no overlap in trading hours with the Chinese exchanges.  Now instead of riskless arbitrage the 2nd tier liquidity providers take significant risks if they buy or sell ECNS shares.  They will do these transactions, but not without requiring a significant premium to sell you shares or a discount in buying shares from you.

 

What About Exchange Traded Notes?

 Although the term ETF is used generically to reference all exchange traded products, a subset of funds called Exchange Traded Notes (ETNs) handle things differently than the example above.  While ETFs explicitly hold the securities specified in the index they track, ETNs link to their index without revealing how they hedge their exposure to market moves.  In practice ETN issuers do hedge their positions, but usually with derivatives like swaps or options that are less expensive than the actual underlying securities.

When an ETN’s shares are redeemed issuers pay out cash according to the Net Asset Value (NAV) per share rather than exchanging securities.  If the AAG example above was an ETN the Authorized Participant would cover their short positions themselves by buying Apple, Amazon, and Google shares at day end rather than obtaining the offsetting securities from the issuer.  If the underlying securities are liquid the arbitrage transactions by 2nd tier liquidity providers are just as effective for ETNs as they are for ETFs.

 

Evaluating Market Depth

 As a liquidity cross-check for ETFs and ETNs you can look at their Level 2 market depth.  These reports tell you not only how many shares are being offered at the National Best Bid and Offer (NBBO) quotes, but also can give you an indication of how much additional liquidity is available if you are willing to pay a premium on a buy or accept a discount on a sale.

The Level 2 Schwab StreetSmart Pro screen shot below of market depth is for Direxion’s Lightly Leveraged  Daily S&P 500® Bull 1.25x Shares (LLSP), an ETF with low daily volume.  Its underlying is the S&P 500— probably the most liquid security in the world.

Bid-LLSP-liq

The numbers on the far right indicate the number of shares various market participants are willing to sell at the prices listed in the middle.  The share amounts shown are minimum amounts—other players like High Frequency Traders (HFT) and dark pools will likely jump in with additional liquidity if a buyer appears.   The top two depth lines are essentially a duplicate, showing that the quote provided by the “arca” exchange is the current overall best bid.

A market order to sell 1000 shares would likely sell 600 shares at 26.64 and the remaining 400 at 26.63—a mere 0.04% less than the initial bid value.

A limit order to sell 1000 shares would probably fill entirely at 26.64 within a few minutes.

The next screenshot shows the level 2 quotes for another low volume ETF— iShares’ MSCI China Small-Cap (ECNS).  It does not have good liquidity even though it holds more than 20X the assets of LLSP.

bid ECNS-liq

A market order (not recommended!) to sell 1000 shares of ECNS would likely clear the book down to the 47.45 level—a big 2.3% drop from the starting bid price of 48.57.  A limit order at 48.57 would enable you to sell at least 300 shares at that price, but there is a good chance the rest of order would not fill because the next official bids are 0.5% lower.  The illiquidity of the underlying stocks makes it unprofitable for the tier 2 liquidity providers to offer better prices.

 

Some Investigation Required

Unlike a small cap stock you can’t judge the liquidity of an ETF or ETN by its daily volume or assets under management.  A quick look at the securities underlying the fund will spell out the real liquidity story—it’s dumb to use small cap rules of thumb.

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