ETFs: More liquid than you think
30 October 2017 | Tom Bartolacci
Despite the large and growing pool of assets from institutional and retail investors, some investors are ruling out exchange-traded funds because of liquidity fears. These worries show how ETF liquidity is misunderstood.
What is average daily volume?
There are many layers to ETF liquidity. Probably the most frequently cited is average daily volume (ADV), the average of the amounts traded in the ETF each day. A high ADV typically means there are plenty of buyers and sellers and ETF shares can be easily traded. If it's low, it's assumed that liquidity is low and potentially trading in the shares could move the price. Investors using only this metric as an indication of liquidity are more likely to favour ETFs with higher ADVs than those with lower.
Liquidity is more than ADV
But the ADV figure doesn't represent the depth of an ETF's true liquidity. In fact, it accounts for just a fraction. If you disregard an ETF based on a low ADV, you could be unnecessarily limiting your investment options.
The underlying markets
The largest source of ETF liquidity by far is the underlying market. This is the ability to create or redeem ETF shares by going to the primary markets and buying or selling the fund's underlying investments. For a FTSE 100 firm, this is the London Stock Exchange. For a US blue chip company, it could be the New York Stock Exchange.
The liquidity of these underlying markets comes from the multitude of buyers and sellers acting together to create those markets. Investors using these large, well established exchanges can transact in liquid securities knowing that their decision to buy or sell will not disrupt the market price. What may be a large purchase in the ETF, requiring the creation of new ETF shares, translates into much smaller trades in the portfolio's underlying securities. This creation process, by authorised participants, means an ETF's liquidity comes from the liquidity of the securities in its portfolio.
But buying an ETF does not always lead to the creation of ETF shares, nor does selling it always lead to redemptions. A further layer of liquidity comes from trading in the secondary markets, in which brokers match trades among those who are buying and selling the ETF. This is either on the exchange or over the counter (OTC).
This source of liquidity removes the need to trade in the underlying market, saving on commissions and trading taxes and levies. And it is one of the key differences between an ETF and a mutual fund, which requires investors to trade with the fund rather than among each other.
Traders and brokers can help
Investors who understand that there is more to ETF liquidity than ADVs have more choice. They won't rule out an ETF based on its ADV measure, which could easily result in excluding viable investment vehicles that give effective, low-cost exposure.
When assessing ETF trades, look beyond the on-screen metrics. Speak with your trading desk or brokers, or even the ETF provider's capital markets desk. They can give you the up-to-date liquidity picture and the likely costs involved in trading, which keeps your options open when implementing portfolio strategies.
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