Highlighting ETF liquidity during times of stress

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Our team continues to explain the merits of utilising the exchange-trade fund (ETF) vehicle to a whole new wave of investors. This most recent wave was born of the fallout from the Ukraine war, when we started to hear the question: how is it that the ETF vehicle was the only source of liquidity that allowed an access point for buying and selling Russian securities in the initial aftermath of Russia’s invasion? The unfortunate circumstances have led many investors to seek a greater understanding of ETF vehicles. If there were a chapter in ETF history that highlighted the need for a liquidity sleeve in investment portfolios, I think the events of recent years should certainly be included.

Indeed, it is this liquidity that so many investors are now embracing, in addition to the ETF’s attributes of low cost and transparency.

In recent years, I have outlined and dispelled myths around ETF liquidity in my posts, and now, many investors are seeking this attribute in their portfolio planning. So, I’ll take this opportunity to remind potential investors of the features that make the ETF vehicle the only fund investment vehicle—in my opinion—to bridge the analogue-to-digital fund distribution landscape.

ETFs are open-ended investment funds; that is, the number of shares in issuance can increase or decrease daily depending on supply and demand. This open-ended feature can be thought of in the same way as an efficiently functioning supply chain. For example, if you want to buy a car, you would normally go to a car dealership (physical or online). At a used car dealership’s lot (forecourt) in the United Kingdom, you could find a secondary market of second-hand vehicles. Think of this forecourt buying as analogous to buying an ETF on a stock exchange, with the forecourt acting as the exchange.

Alternatively, if your preference (size of car, colour, trim, etc.) is not available on the forecourt, the dealership will look to the primary market, i.e., a brand-new, factory-ordered vehicle for you. Understanding and appreciating the features of these secondary and primary markets is key to appreciating the liquidity and trading benefits an ETF can provide.

Now, under normal circumstances, the price of cars on the forecourt—even if fairly new—will never be higher than the retail list price for a brand-new vehicle. Think of this in terms of liquidity! (We will ignore lead times for building a new car for the moment). The price of buying a new car is always a function of and finitely based upon the production cost and delivery of the “underlying” product. ETFs operate in a similar fashion.

Existing shares of an ETF can be bought or sold at any point during the trading day just like a stock. If there is a mismatch between supply and demand, then ETF shares are created (creation) or terminated (redemption) to meet the requested supply/demand. Hence, the price and liquidity of the ETF is finitely dependent on the underlying stocks just like the production cost and delivery of a new vehicle. I have often pointed to this open-ended feature as a key to appreciating liquidity, and have dispelled the myths around the issues of size when selecting an ETF (see my previous post, “Back to the Basics Around Liquidity”).

However, since the start of this year, the world has seen some abnormal events. We’ve seen the tragic invasion of Ukraine coupled with persistent global supply chain issues that are tied to the ongoing pandemic. These scenarios offer an opportunity to explain ETF liquidity. Sticking with the example of cars, the ongoing issues around global microprocessor production and delivery has had such a knock-on effect that lead times for new vehicle (primary market) production has resulted in wait times that have been well over the long-term average for delivery of a new vehicle to the end consumer. And for the first time in my life, we’re seeing prices in the UK second-hand car market trend upward.

So, what does this have to do with ETF liquidity? In a similar fashion to the issues we’ve seen with supply chains, when Russia initially invaded Ukraine, the local Russian stock exchange was closed, and secondary market access to the buying and selling of underlying Russian securities was halted. Hence, no primary market activity could occur in Russian stocks or Russian ETFs. However, secondary market trading in Russian ETFs listed around the world was still occurring, and the buying and selling of Russian ETFs on the secondary market was the only option available for investors.

The robustness of the ETF ecosystem allowed investors to navigate these uncertain times as it has during past instances of market stress. And while many mutual funds were gated, meaning they left investors unable to redeem shares, having an ETF as a liquidity sleeve made all the difference for those looking to liquidate their Russia exposure.

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. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets.

For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.

ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. 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. 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.

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