InvestmentsMay 16 2016

Using ETFs to ease liquidity challenge

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Using ETFs to ease liquidity challenge

While liquidity has deteriorated in asset classes such as fixed income and high yield, exchange-traded funds (ETFs) have brought a welcome additional liquidity venue for these markets.

Although it may not be discussed much among advisers, ETFs and underlying market liquidity is a topic of interest in the ETF market at the moment – and one that is relevant for advisers, too. Why?

Partly because we are seeing more ETFs tracking bond markets, where the underlying securities trade off-exchange and where, in some cases, the underlying market is less liquid than the ETFs tracking it. Does this matter? Should it be of concern, or is it a good thing?

A recent research paper by Deutsche Asset Management looked in-depth at the issue, focusing on bond and emerging market equity ETFs – another area where the ETF might be tracking a less-than-liquid market.

The first thing to establish was what precisely is meant by market liquidity. Some people think of this simply as the spread – the bid and offer price – that a security trades at. The reality, though, is more nuanced.

As well as tightness of the market as expressed via bid-offer spreads, the depth of the market (the existence of large and balanced trading books by many intermediaries), the breadth of the market (consistency of liquidity across various securities from a particular asset class), and the immediacy of the market (time required to complete a transaction) are also important factors when assessing liquidity.

This has left a liquidity and access challenge for big investors who need fixed income exposure Vincent Denoiseux, Deutsche Asset Management

This has left a liquidity and access challenge for big investors who need fixed income exposure. Fixed income ETFs have emerged as part of that solution. But this poses questions if the fixed income ETF is more liquid than the underlying market. Although the emergence of fixed income ETFs on less-than-liquid underlying markets does not in itself increase the liquidity of the underlying market, it does create a useful new liquidity venue for buying and selling fixed income exposure.

ETF trading takes place on both the primary market, where ETF units are bought and sold from broker-dealers authorised to create and redeem shares, and also the secondary market, where ETF shares change hands entirely between buyers and sellers without recourse to creation or redemption of ETF units. A surprising finding from the study was that in the case of large, mature ETFs, even when the underlying market is selling off, much of the liquidity needs of sellers can be met in the secondary market. This is because ETFs fulfil a range of investment functions, with investors having different holding periods. In other words, it’s not just fast money – there are lots of buy-and-hold investors and others creating a diverse investor base, meaning the market generally does not become completely one-sided.

Another finding was the construction process for ETFs focuses on the most liquid segments of an asset class, meaning the index will be subject to rules – perhaps excluding some very illiquid securities – that improve liquidity. Furthermore, in replicating the index, the manager might optimise portfolio construction to further improve liquidity.

But that is all theoretical. What happens in the real world? Looking at some real-life scenarios, notably the December 2015 US short-term high-yield credit crunch, to analyse what happened to the relevant market ETFs during these periods reveals a number of things.

The evidence so far is that ETFs tracking less-liquid market segments, such as high-yield bond markets, in the main have helped to enhance market liquidity, with a substantial amount of trading done on a two-way basis in the secondary market alone. Although this does not increase liquidity of the underlying market, the additional liquidity available is beneficial to market participants.

It is fair to say that the emergence of ETFs on less-liquid underlying markets is a useful tool for investors seeking those exposures, and this is especially true for fixed income, where the development of this ETF market is part of the solution to meeting investor demand for underlying exposures.

Vincent Denoiseux is head of ETF quantitative strategy at Deutsche Asset Management