In the most recent periods of heightened market volatility, we’ve seen renewed interest in our fundamentally weighted multi-factor approach to exchange-traded funds (ETFs). In addition, we have fielded many questions about how such structures trade in these conditions.
So it seems like a good moment to pause and consider the liquidity of ETFs. Firstly, let’s remind ourselves of the basics: ETFs are index-tracking, open-ended investment funds which trade around the globe on regulated stock exchanges. Indices are developed and weighted according to either a market-capitalisation weighting approach or a fundamentally weighted approach.
Dual Sources of Liquidity
So, there are actually two sources of liquidity in an ETF. The first is the liquidity of the ETF itself (how easy it is to buy or sell it); the second is the liquidity of the underlying assets in the ETF. If the underlying stocks are easy to buy and/or sell, the ETF should also remain liquid.
These considerations are equally true for ETFs built on market-capitalisation weighted indices and fundamental-based ETFs constructed using other factors. In practice, both market-cap and fundamental-based ETFs use the same investment universe to select stocks. The difference is in the construction, particularly in regard to weighting.
Market-cap indices weight stocks/bonds based on their size representation in the market—the larger the company, the higher the weight in the index.
Fundamentally weighted indices use factors to weight the underlying constituents. These can be single factors or a combination of factors to create a multi-factor weighted product. This alternative (factor-driven) approach to construction is referred to as a smart beta ETF (See sidebar).
The Momentum Factor
Since the global financial crisis in 2008-2009, momentum has emerged as a dominant underlying factor. But, in our view, the coordinated central bank action to facilitate liquidity through low interest rates and quantitative easing has created an artificial environment.
Market declines like those seen so far in 2018 give us a glimpse of historically a more typical market environment.
In times of increased volatility, investors may look for stocks exhibiting better fundamentals around return on equity, earnings variability or cash return on assets.
Of course, simply choosing quality stocks is not enough. We think ensuring those quality stocks exhibit attractive valuations is just as important.
Building a portfolio with securities showing solid fundamentals combined with attractive valuations could offer the potential for better risk-adjusted returns over the long term. And, we think it can offer a more defensive play amid conditions of heightened volatility.
In our next article, we will continue our discussion of ETF liquidity and look at some of the myths and misconceptions about trading ETFs in Europe.
The comments, opinions and analyses are the personal views expressed by the investment managers and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.