Beyond Bulls & Bears

LibertyShares

The Liquidity Story

When considering an investment, many regard liquidity to be a “must-have”. As the subject remains a focus for investors in exchange-traded funds in particular, our Head of EMEA ETF Capital Markets, Jason Xavier, dives a little deeper into this topic. He explains how many investors might not be looking at the full picture when thinking about liquidity.

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.

To get insights from Franklin Templeton delivered to your inbox, subscribe to the Beyond Bulls & Bears blog.

To comment or post your question on this subject, follow us on Twitter @FTI_Global and on LinkedIn.

Important Legal Information

This material is intended to be of 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.

Any companies and case studies shown herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The opinions are intended solely to provide insight into how securities are analysed. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security. Past performance is not an indicator or a guarantee of future results.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com—Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton’s U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

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.