And, given the extraordinary times that we are living in today, understanding ETF liquidity has never been more important.
Liquidity has become a key focus for regulators and fund issuers alike.
How do you measure the liquidity of an ETF?
One of the biggest misconceptions with ETFs is the notion that you can generalise their liquidity based on their structure.
ETFs come in many shapes and sizes, tracking a wide range of asset classes, therefore it is impossible to generalise. However, it is not the ETF structure itself that determines the liquidity of the ETF.
Like any mutual fund, it is the underlying assets that the ETF is invested in that determine its liquidity.
Key Points
- ETF liquidity is important in difficult times
- It is the underlying assets that the ETF is invested in that determine its liquidity
- A misconception around ETFs is that those with lower AUM are less liquid
While typically investors can measure a company’s liquidity based on the value that trades on exchange, the same measure cannot be used to gauge an ETF’s liquidity. It is wrong to look at the value of shares traded of the ETF itself.
In order to assess the liquidity of an ETF (that is, how readily you can buy or sell shares of the ETF), you have to look at and assess the liquidity of the assets held by the ETF.
Why do an ETF’s assets determine its liquidity?
For example, a FTSE 100 ETF will hold all of the composite companies matching the percentage weights in the index. If you want to invest £10m in that ETF, the ETF investment manager needs to be able to buy £10m worth of shares in the companies that make up the index.
Therefore, the ETF will have a liquidity profile matching the FTSE 100 companies’ liquidity.
Comparatively, an ETF that invests in a basket of high-yield bonds, will be as liquid as those bonds.
As different asset classes (bonds, equities, commodities, real assets) exhibit different levels of liquidity, their respective liquidity profiles will be reflected in the corresponding ETFs that are designed to provide exposure to them.
Why can ETF exchange liquidity be misleading?
Exchange liquidity is dependant primarily on the ability of the market maker to create and redeem in the primary market, and to hedge their position (buy or sell the ETF’s underlying assets) prior to trading in that market. So, the amount available to buy or sell depends on whether the underlying assets of the ETF can be easily bought and sold.
An ETF can have zero shares traded on exchange or have vast numbers of shares traded on exchange, however, again, what really matters is the underlying assets.This is a crucial part of understanding ETF liquidity.
For example, if a FTSE 100 ETF has zero demand from investors and therefore shows no volume traded, a traditional view of liquidity will say that the ETF is illiquid, that it cannot be easily bought or sold by investors.
However, an ETF is not an individual stock or share, but instead an investment fund that only requires liquid underlying assets to be liquid at the fund level.
Therefore, ETF liquidity needs to be looked at differently to traditional stocks or shares liquidity.
In our example, having zero ETF shares traded for even a year has no impact on the ETF being able to trade $50m (£38m) in a single day. This is because the investment manager of the ETF can invest $50m dollars into the FTSE 100 companies with no issues.
Therefore, all it exhibits is investor demand in that particular ETF, not its level of liquidity.
Even if we look at a more illiquid underlying asset, for example junk bonds, the story is the same. In normal circumstances, a popular junk bond ETF may have significant volume on exchange as investors buy and sell the ETF throughout the day.
In more extreme market conditions where investors all sell at the same time, the underlying bond liquidity is tested, but again, the exchange volume of the ETF itself is not a relevant indicator of liquidity.
The investment manager needs to sell the underlying junk bonds to other buyers who may be few and far between. This is the relevant aspect of the ETF’s liquidity profile.
Does size matter?
A common misconception around ETFs is that those with lower assets under management are less liquid.
This is not necessarily true, and again, what typically matters most are the underlying constituents that need to be traded when the ETF is bought or sold.
The other ETF size consideration is whether the ETF has sufficient assets to effectively hold and therefore track the underlying constituents of the index.
For example, if an ETF tracks a corporate bond index with 1,000 bonds, it may not be able to do that effectively with $1m.
But this is a separate point to liquidity.
If we take a FTSE 100 ETF that has $1m in total AUM, an investor might be wary of investing for liquidity reasons. However, an investor can very comfortably invest $50m in a day bringing the total assets to $51m, due to the liquidity of the underlying FTSE 100 companies.
All that has happened is that the investment manager has bought $50m of the underlying companies in the index and they can redeem them the next day if they wish, with zero effect on the functionality of the ETF.
The liquidity of ETFs has long been misunderstood and, sometimes, misrepresented. It is the underlying assets that determine true liquidity, not the structure of a fund.
Anthony Martin is a co-founder at Rize ETF
