Tom Kingsley, Head of Execution APAC and Gary Stone, Chief Strategy Officer, Bloomberg Tradebook look at the link between increasing institutional ETF use and closing auction volume.
ETFs are a growing global phenomenon. The number of exchange-traded funds and their associated assets under management has exploded since the 2008 financial crisis. This includes ETFs that are Asia-equities focused. According to the Bloomberg Professional® service “fund search” (FSRC <GO>) analytic (Figure 1), 100 to 120 new Asia-equity-focused ETFs have launched each year since 2010. Total assets under management are approaching $28tn (Figure 2). ETF growth doesn’t look likely to slow — what started mainly as a retail product to provide passive exposure to sectors and geographies is now becoming a tactical portfolio management tool for institutional investors to gain long-term exposure to a sector or an asset class through an equity-traded product. According to a recent Greenwich Associates survey, 18% of institutional funds now include ETFs in their portfolios, compared with 14% in 2012; in addition, half of the institutional investors surveyed said that they intended to increase their ETF allocations by 2014. During the same time that ETFs have grown, closing auction volumes have also risen (Figure 3) as a percentage of ADV, making them a significant liquidity event. This raises the question: Are ETFs changing Asian market structures?
Human beings tend to assume that two observed events that seemingly happen together must be associated in some manner. Any two observed events could be attributed to correlation, causation or coincidence. In the world of finance, a correlation is a statistical measure of how two securities move in relation to each other. Causation is a trigger—one event triggers the other, while a coincidence means that events happen at the same time but not enough observations are available to establish statistical significance or the presence of a clear trigger. Although the data at this point isn’t clear, some anecdotal evidence supports the view that the explosive ETF growth is contributing to the growing significance of the closing auction. Some suggest that this may be because, according to authorised participants, institutional block orders for ETFs are executed at the close. The authorised participant (AP) will tap the primary market to satisfy the block. This is accomplished by the AP buying the constituent stocks in the auction at the official closing price and then submitting the basket to the fund administrator to receive an ETF at the closing day’s net asset value. Some are suggesting that this is contributing to the closing auction becoming a more significant liquidity event.
Bloomberg Tradebook’s quantitative research group found, not surprisingly, that although closing auction liquidity growth is affecting the majority of stocks, its impact is uneven. Because closing auction information is not readily apparent, traders need analytics to bring insights to the surface to help them make statistically guided and better decisions.
Deeper closing auction liquidity has several implications for popular trading strategies. For example, prior to the closing auction becoming a significant part of the ADV, a VWAP strategy could ignore it because the closing auction would have minimal impact on the average. Now, algorithms have to interact or at least provide the trader with the option of including the closing auction in the strategy’s volume profile.
Additionally, traders and portfolio managers may want to participate in close because the liquidity event could offer an opportunity to pick up size. Asia’s closing auctions, however, are not straightforward and are difficult to trade. Auction buildups are volatile and unpredictable. Prices and volumes change throughout an auction, thus predicting the uncrossing price becomes difficult. Many of the region’s auctions do not support market orders or pegged limit orders. Setting limits and resetting limits is manually intensive, so trying to simply place an order in a crossed market increases the risk of an order not being filled. Special closing auction algorithms are, therefore, needed to efficiently manage orders. They must be able to predict price and volume based on the buildup information and adapt to changing dynamics. Order placement is critical — parent orders have to be split into several “child” orders to establish queue position, hide footprints and effectively adapt to changing auction conditions. Asia’s market structure is changing — closing auction volumes are becoming more significant. At best, the growth in the region’s ETFs appears to be coincident with the growth in volumes in closing auctions. Nevertheless, the changing auction dynamics demand new technology. New analytics, such as Tradebook’s STAZ <GO>, are needed to provide traders with closing auction ADV to determine if execution strategies need to consider interacting with the closing volume. And, because auctions are difficult to trade, special algorithms are needed to execute efficiently.
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