We have all read about the meteoric rise of ETFs causing the displacement of traditional mutual funds in retail brokerage accounts and IRAs. We have also seen ETFs become commonplace tools for exposure in institutional portfolios. But 2023 may become known as the year that ETFs began displacing mutual funds in asset allocation strategies, both risk-based and target date structures.

To most institutional investors, the benefits are obvious: lower cost, greater tax efficiency, and intra-day trading. However, before embarking on the transition of your asset allocation strategies to ETFs, fund sponsors should take time to understand the trading characteristics of potential ETF strategies. While most ETFs may appear liquid, the ability to trade large blocks depends on a number of factors, including the ease of creation and the liquidity of the underlying securities.

Read on for our perspective on some of the most essential things for market participants to know in the world of ETF trading.

ETF Trading Strategies – How Do ETFs Trade?

How should ETF orders be handled? The short answer: it depends. The longer answer: size matters and competition is key. When it comes to small orders, ETFs trade like listed stocks: transactions are generally executed in seconds at or near the NBBO. However, when it comes to larger orders, ETFs trade like bonds. That’s a critical nuance for anyone to understand.

Unlike traditional stocks, the ease of trading large blocks is not always tied to the average daily volume. Instead, the ETF creation process is often the driver of liquidity. Choosing ETFs that are easy to create makes it more likely that you can buy or sell large blocks with very little slippage. Those that are harder to create – such as emerging market ETFs – tend to be less liquid. The ability to hedge the underlying securities also increases the likelihood that large blocks can be executed with minimal slippage.

All this means that for larger orders, putting market makers or authorized participants (APs) in competition with one another becomes key to finding the best price. A brief word on APs: these are broker-dealers that have the ability to create and redeem shares by transferring the underlying basket to the trust.

It’s essential to have a wide network of AP and market maker relationships. These firms tend to become more aggressive when they have the opportunity to flatten their overall position, potentially offering more favorable pricing. A comprehensive request-for-quote process with the ability to solicit multiple two-sided quotes is crucial when executing large blocks. No single AP is always best. Buy-side and sell-side firms alike often find it difficult to maintain this level of recognition among APs, whether because of their resources or structure, but it is an important success factor to consider.

For CAPIS’ part, our ability to offer tier-1 pricing from multiple market makers and APs is a key aspect of our approach to ETF trading – more on that below.

ETF Trading Strategies in Action: Experience the Difference

At CAPIS, trading excellence, transparency, and trust are the foundation of all that we do. We work with clients of all sizes and employ a wide range of strategies and technologies to help meet their goals, including in the ETF market.

Consider an ETF-based asset allocation fund. Rebalancing these funds requires a market-neutral trading approach – during the trade, any exposure imbalance creates risk. Trading both buys and sells at an equal pace can require a combination of open market transactions and block trading strategies. By combining years of experience with leading-edge technology, our program trading team can effectively manage the unique risks of trading entire baskets of stocks and ETFs, leveraging the right tools and algorithms to help deliver best execution and overall efficiency.

That’s just one example. The bottom line: whatever your specific ETF trading needs, CAPIS can help. We maintain multiple AP relationships with tier-1 pricing. We provide detailed post-trade analysis based on implementation shortfall statistics, so you can see our strategy in action. And we do it all, with a client-focused, consultative approach – we’re always happy to sit down with you, discuss your ETF trading goals, and put our best foot forward toward a successful long-term relationship.

Want to get started? Reach out to us about ETF trading today.