With the popularity of exchange-traded funds (ETFs) growing globally, it’s clear that more and more investors are embracing the benefits of the ETF wrapper. As our team has highlighted in the past, these include low costs, transparency and liquidity.
The last point—liquidity—is something most investors say they want, but in our experience, it is often misunderstood. So, here is a deeper analysis on why we think investors should think differently about liquidity when it comes to ETFs.
Liquidity and the metrics used to measure it are important considerations for many investors. The most commonly used way to measure liquidity in an investment vehicle is the number of shares traded over a certain period, represented by average daily volume (ADV). Let’s take a closer look at this.
As a reminder, ETFs generally share the same trading characteristics of individual stocks. Both trade in the secondary market, either over the counter or via a regulated exchange.
However, a key difference is in the issuance. Stocks typically have a finite number of shares issued. Hence, the limited number of outstanding shares will impact the supply and demand dynamics and influence the price, trading and liquidity of each stock in question.
ETFs are open-ended funds meaning the number of shares in issuance can increase or decrease depending on supply and demand. Hence, the true liquidity of an ETF is not the observable metrics for a particular fund in question, but rather, the underlying metrics for the stocks or bonds that make up its underlying holdings.
Here is a simple example:
Let’s say a US equity ETF tracks the Russell 1000 Index (RIY). It will, thus, have access to the liquidity of the underlying constituents of the index. We know that the stocks represented in the RIY trade on average US$12 billion per day.1
US Equity ETF
Average Daily Volume: US$6 million
Russell 1000 Index
Average Daily Volume: US$12 billion
While our US Equity ETF in this example trades US$6 million per day, it is wrong to assume that this limits the available volume to a proportion of that figure. Why? Because, as noted, you have to consider not only the ETF’s liquidity, but it’s underlying basket of stocks. The ETF’s underlying assets track the Russell 1000 index, so it actually has a pool of over US$12 billion in notional funds to invest in, which is very deep and liquid. An investor should be able to execute trades in the millions or even over a billion dollars in the ETF without having any major issues.
Of course, many investors feel the higher average daily volumes in the ETF, the better. There’s a perception it will be easier to enter and exit a position, and that higher volumes and tighter spreads (the difference between the bid/ask price) mean lower prices. That is not always the case.
But what about a new ETF—one that is just starting to trade? The same situation in regard to its underlying basket and liquidity applies. And remember, when there are more existing holders of an ETF looking to sell than there are new investors looking to buy, there are market participants known as authorised participants and market makers who would step in as buyers and facilitate liquidity. The price at which those market participants would purchase the ETF would be driven by the price at which they could sell the underlying basket, since they would most likely need to redeem shares.
For ETFs that have highly liquid/large underlying baskets (like our example above), we would expect the price of a high average volume ETF to trade at similar levels as another newer ETF with low average volumes because of that high basket liquidity.
In conclusion, from our point of view, an investor considering an ETF should focus more on how that product fits within their broader portfolio and provides the exposure he/she seeks, than whether it trades a certain number of shares per day.
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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.
1. Source: Franklin Templeton Investments Trade Desk team. The Russell 1000 Index is a US equity benchmark representing 1,000 of the largest companies in the US market by market capitalisation. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.