Spy Delivers on All-Weather Execution

The breakout of the COVID-19 pandemic and ensuing market volatility in March last year has led many institutional investors to reassess their liquidity management program. During that time, reduced liquidity hit several securities, including widely traded S&P 500 exchange-traded funds. However, for the largest S&P 500 ETF — State Street Global Advisors’ SPDR S&P 500 Trust ETF (ticker: SPY) — the unprecedented volatility spike last year turned out to be a test case of its resilience, liquidity and efficiency in a stressed trading environment.

“ETF asset growth and the number of products in the market [had previously occurred] over a relatively long period of low volatility, with some isolated exceptions. We had not seen a stressed market like the one we saw in March 2020 in a long time,” said Colin Ireland, head of SPDR sales execution and institutional strategy at the firm. “For a lot of due diligence teams that may have felt they understood liquidity, the extended period of high volatility and constrained liquidity was surprising and, in a lot of ways, historic.”

That experience has led to a reassessment of ETF due diligence and product selection in terms of adding input from the trading environment in a more rigorous manner than ever before, Ireland said. “Investors who were perhaps not as focused previously on execution and transaction cost analysis are now understanding that trading costs are dynamic; they’re not a fixed cost that can be modeled out in a low-volatility environment.” The total cost of ownership of S&P 500 ETFs, including SPY, includes not only the expense ratio but also transaction costs and their impact in different market environments, he said.

Consider total costs
“If you think about SPY’s transaction costs, they were significantly lower than other ETFs during
that period,” Ireland said. Also significant was that “from a flexibility standpoint, SPY provided a lot more access to liquidity and its deep secondary trading offered an alternative execution strategy, particularly relative to some other funds that were executed through different strategies or through high-touch order types.”

SPY was the first ETF to trade north of $100 billion in a single session on February 28 last year.¹ While there have been other securities that have reached that level since that time, SPY offered a unique access to liquidity and depth of liquidity in a stressed — and unexpected — market environment, he noted.

“SPY’s flexibility and the additive liquidity of secondary trading during the volatility period of March 2020 was, ultimately, a case study for what is and should be very important in the ETF product selection process.”

Evaluate execution type
For investors evaluating ETFs, State Street provides analytics that help them make informed execution decisions, Ireland said. It uses a third-party, pre-trade analytics platform specifically designed for ETFs to conduct a cost-benefit analysis. “We typically break down the three most common execution types into secondary trading, basket trading and risk trading, and then we customize [execution] based on the specific client’s order size and the market environment.”

Secondary trading is effectively electronic trading that typically uses automated pre-programmed trading instructions, Ireland explained. Basket trading refers to trades executed by buying or selling the underlying basket of securities and then creating or redeeming the ETF shares. “In this case, the client typically receives a price reflective of executions for the underlying basket, plus or minus creation and redemption costs, with a fee for the service,” he said. Finally, in risk trading — which is a very popular way to trade — the client receives a price for the entire trade at once, with the liquidity provider taking on the risk of managing the resulting position. “Typically, liquidity providers compete for the trade, so there’s a clear measurement of best execution via the different liquidity providers,” Ireland said.

It’s important for investors to realize that the type of execution strategy is often constrained by the specific product, Ireland pointed out. In the context of the March 2020 event, when considering secondary trading, some S&P 500 ETFs in the market saw their secondary trading become more constrained. On the other hand, “SPY’s secondary trading continued to offer investors immediate access to liquidity. It was anonymous and provided flexibility that was not available in other tickers.”

Similarly, risk trading during that period reflected the risks associated with transacting underlying securities and how quickly the market was moving. “The underlying basket traded wider than it typically did... SPY offered a price improvement relative to the underlying basket and certainly relative to other ETFs,” he noted.

Find the efficient route
In any market environment, and perhaps more so in stressed markets, SPY continues to offer institutional investors the flexibility to trade via any type of execution, Ireland said. “Ultimately, investors are forced to balance trade urgency, cost sensitivity and anonymity in determining execution strategy.”

“We often say there’s no right way to trade an ETF [but] there can be a wrong way,” Ireland said, noting that the latter can include considerations such as timing of the trade or strategies to avoid. With four S&P ETFs in the market — of which SPY is the largest — investors need to select the appropriate product that delivers on their investment strategy.

Investors need to realize that liquidity needs are unpredictable and high volatility can persist for
extended periods — making it critical to consider total transaction costs in the ETF due diligence process – and they should also focus on reliability of the security. “SPY’s secondary trading offers a liquidity valve not offered in other funds. In addition to potentially providing transaction cost improvements, SPY offers a potential for faster electronic trading and a broader menu of ETF execution options that other products [in this space] may not offer,” Ireland said.

“The 2020 environment was effectively just another case study in which investors gravitated
toward the highest confidence products,” Ireland said. Not only did SPY show some of the highest volumes, SPY offered price discovery benefits and it provided investors with liquidity when they needed it the most,” he said. “That’s a persistent trend that we can typically point to the correlation between volumes, depth of liquidity and VIX.”

Look at relative performance
As asset owners reassess their liquidity management program, it’s important they consider vehicle and product selection as an important piece of the process, Ireland said. “We’ve seen a lot of interest from the asset owner community to evaluate SPY as a potential improvement [over their existing program.]”

He added he expects that interest in SPY will be relative to other S&P 500 ETFs due to its liquidity benefits on display during March 2020. “There will also be interest relative to other derivatives products like futures, as SPY’s transparency and liquidity during that period was also improved relative to traditional liquidity sleeves like the E-Mini S&P 500 futures,” he said, referring to a futures contract that represents one-fifth the value of a standard S&P 500 futures contract.

As asset owners engage in the evaluation process, Ireland offered three takeaways to keep in mind: total cost of ownership, secondary trading as an additional liquidity valve, and ability to provide liquidity to many different types of investors, particularly when they most need it.

¹Source: Bloomberg; SSGA Research 09/30/21

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