Understanding how to execute a low-cost ETF trade

A particular day late last year on the Vanguard ETF trading desk sticks in our minds as a teachable moment. While we’ve talked generally about approaching ETF trades with care, one trade on a December day just before Christmas stands out because it was a really big trade and we helped get it done smoothly and with minimal transaction costs.¹

The trade, which involved Vanguard Total Stock Market ETF (VTI), was worth $238 million, or 28% of VTI’s total average daily volume (ADV).² If the trade had been placed without sufficient thought, the result could have been a poor execution with substantial transaction costs, to the detriment of VTI investors. And given the relatively low holiday-week volume, the risks of a conspicuous, expensive trade were higher than normal.

But our story had a happy ending because the big trade got done with minimal transaction costs. In other words, the trade got done right on the ask of the bid-ask spread—a result that fell well within the bounds of a successful transaction, as we will show in a chart below that illustrates the VTI trade.  

What we did to pull that off, and what we seek to do whenever we take a call on the Capital Markets desk to help a client smoothly execute a big or complex ETF trade, was to leverage the distinct features of the primary and secondary markets in terms of ETF liquidity. The liquidity provider’s use of these features—and our guidance to clients on how to utilize these features to their advantage—is designed to keep trading costs as low as possible.

Keeping the total costs of ownership (TCO) of an ETF as low as possible means understanding a raft of important ETF characteristics, including bid-ask spreads, premiums and discounts, and the interplay between ETF primary and secondary market liquidity. As a trade grows larger, so does the risk of higher execution costs. This is when a solid understanding of market liquidity and the people who can help find it comes in handy.

The genius of ETFs

Today, U.S.-listed ETFs represent about $7.5 trillion, and ETFs typically make up at least 25% of the dollar value of all daily stock market volume.³ It’s clear that having two robust layers of liquidity—many exchange-traded securities packaged inside a trading vehicle that itself is also listed on an exchange—has been crucial to the rise of ETFs.

Specifically, somewhere between 80% and 90% of all Vanguard ETF volume last year occurred on the secondary market.⁴

That means that 10% to 15% of that volume of Vanguard ETFs is linked to the primary market. That’s where ETF shares are created (or redeemed) by capital market professionals called authorized participants and market makers.

These professionals seek to keep supply of ETF shares in the secondary market in line with demand, by adding new ETF shares (creations) or removing ETF shares (redemptions). Their primary focus is to facilitate an orderly market to build confidence that investors can find liquidity when they need it.

All ETFs are listed on a stock exchange, even if their underlying assets aren’t equities. That means that historically difficult-to-trade assets, such as bonds or commodity futures that are part of an ETF, benefit from the secondary-market liquidity. 

Percentage of Vanguard ETF® trades in 2022 that took place in primary and secondary markets

Notes: Data pertain to Vanguard’s 82 U.S.-listed ETFs. The 82^nd was launched in March 2022.

Source: Vanguard, using data from January 2022 through December 2022.

Finding liquidity in the market

The secondary market is where any investor with a brokerage account can access the universe of U.S.-listed ETFs. ADV reflects the state of an ETF’s secondary market, and investors can use ADV to assess the likelihood of fulfilling their trades. With so much volume staying in the secondary market, many ETFs trade independent of the costs of their underlying constituents. They trade off supply and demand for the ETF itself, and the price reflects the turnover and volatility of the ETF. 

That ready accessibility of ETF shares on a stock exchange means that ETFs are often trading at lower cost in the secondary market than they would if they were accessible only in the primary market. Trades in the primary market in most cases would be more expensive, and operationally more difficult, than a straightforward brokerage account trade in the secondary market.

Only when the demand is greater or less than the supply does the primary market for ETFs kick in, providing a crucial additional layer of liquidity. This additional liquidity depends greatly on the liquidity of the underlying securities in the portfolio.

That said, although some ETFs may have liquidity constraints related to their underlying securities, almost all the ETFs in Vanguard’s lineup have broad diversification, which helps smooth out trading of the ETFs on an exchange in the secondary market. This diversification helps to ensure that no single security weighs too heavily on the overall liquidity of the fund.

Using Vanguard S&P 500 ETF (VOO) as an example, you would need to trade $1.5 billion of the ETF to move just 1% of Apple’s (AAPL) average daily volume. In other words, a VOO creation unit of 25,000 ETF shares contains about 4,062 Apple shares, and AAPL trades more than 55 million shares on an average day.⁵ That means it’s difficult to move the price of Apple on a stock exchange, even with the creation (or redemption) of 25,000 VOO shares in the primary market.   

The two layers of liquidity create great opportunities for investors to make large transactions in the ETFs and get executions that are fairly priced, because the market makers will first review how much they might be able to trade out of in the secondary market. And the second layer that market makers will consider is the market impact of the underlying securities, which is often minimal given the diversification.

The big VTI trade revisited

All this takes us back to the VTI trade we helped execute successfully last winter.

We were able to make use of both primary and secondary market liquidity to trade the $238 million of VTI shares. VTI’s ADV, while plentiful, was not a significant concern in that trade. That’s because the market maker tapped into the primary market liquidity of the underlying securities in the ETF’s basket to provide great execution quality for the client in the secondary market.

And since the basket of securities underlying VTI is so diverse, the ETF’s liquidity helped to protect the underlying securities from having market impact.

Again, to make the point crystal-clear, the trade was executed exactly on the ask, which means with minimal transaction costs to the investor, as the chart below shows.

Anatomy of a large VTI trade

Source: Vanguard Spread Analytics tool; December 22, 2022, trading session, ETF bid/offer and basket bid/offer.

Past performance is no guarantee of future results.

Takeaways

This story has a happy ending that had minimal costs because we approached the trade with full awareness of how to leverage an ETF’s primary and secondary market liquidity in service of optimal trade execution. Still, some investors may be hesitant to use ETFs to achieve certain exposures within their portfolio because of liquidity concerns.

But as the VTI trade shows, ETF investors have the opportunity decrease transaction costs by engaging with the Vanguard Capital Markets desk to help choose the right trading strategy and tap into not only the liquidity in the secondary market but also the liquidity of the underlying securities in the primary market for large ETF orders.

In the end, the dynamic between both layers of liquidity requires attention and, at times, flexibility.

If your trade is less than 5% of ADV, consider using a limit order or marketable limit order to avoid any unintended executions. 

But, if your ETF trade is more than 5% of ADV, it’s important to pause before placing any type of order.

If the trade exceeds the size available on the bid/offer at the time in the secondary market and could result in ETF shares being created or redeemed, consider reaching out to your sales executive to put you in touch with Vanguard’s Capital Markets desk. 

1 The trade involved a proprietary ETF account Vanguard uses to manage certain client accounts.

2 Source: Vanguard Spread Analytics tool; December 22, 2022.

3 Sources: ETF assets from Morningstar, as of August 31, 2023; volume estimate based on Bloomberg from June 5, 2008, through December 31, 2021.

4 Source: Vanguard data, from January 2022 through December 2022.

5 Source: Vanguard, based on Bloomberg data on August 31, 2023. A total of 58.8 million Apple shares traded on that day.

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Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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