Understanding the ETF liquidity myth

Many investors say they want liquidity, but when it comes to ETFs, few understand it.

Many people think ETFs with lower average daily trading volumes (ADVs) are less liquid than ETFs that trade more often. But ADV is not the only measure of an ETF’s liquidity. The liquidity of the ETF’s underlying securities is just as important a factor, and becomes more important as trade size increases. It’s a result of the ETF’s unique share creation and redemption process.

Creation and redemption process

ETF shares are traded in the secondary market through a broker and, unlike traditional mutual fund shares, usually can’t be created or redeemed by individual investors directly with the issuing fund.

Instead, large institutions—designated brokers and dealers—handle the creation and redemption of shares. The ability to bring shares into and out of the market on a continual basis helps maintain a natural balance between supply and demand, and also aligns the ETF’s market price with its net asset value (NAV).

The creation and redemption process helps reduce market-price impact. Because designated brokers and dealers can bring shares of the ETF in and out of the market as needed to balance supply and demand, the market-price impact dynamics of an ETF differ significantly from individual stocks. This is the case even in ETFs with low ADV, demonstrating that the trading liquidity of an ETF is based not just on the volume/liquidity of the ETF itself, but also on the liquidity of the underlying securities.

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Still, every ETF has a certain liquidity profile based on how easy it is to trade the ETF’s basket of securities and the costs associated with the creation and redemption process, hedging opportunities, and inventory risks. This profile can help determine at what size a trade becomes so large that it’s more efficient for designated brokers and dealers to trade the underlying basket rather than the ETF itself.

How do you know where this crossover point is? There is no simple rule. But proper trading techniques can enable you to execute trades at the best prices, regardless of ADV.

Trading techniques

Be cautious at the market open, when all underlying securities in an ETF may not have begun trading. (Some shares may not have a listed trade immediately; some shares may not open due to material news on the stock.) In such situations, the market maker cannot price the ETF with certainty, potentially causing wider spreads.

After the market opens, consider the status of an ETF’s underlying securities. When the bond market is closed and the stock market is open, spreads on bond ETFs tend to be wider and there is less depth because the market maker has no pricing source. Also keep in mind that Canadian ETFs trade through 4 p.m. EST, while the underlying stocks in international ETFs may have stopped trading hours before.

And be careful at market close, when fewer firms may be making markets in an ETF and fewer shares may be listed for purchase and sale than throughout the trading day.

Traditional market impact is not the same for ETFs

Source: Vanguard

The benefits of a block trading desk

A block trading desk can help with trading large orders. A block trader can execute trades in a number of ways, including:

• Leveraging institutional relationships to trade in smaller increments over time.
• Trading with designated brokers and dealers to create or redeem directly with the ETF sponsor in lieu of effecting secondary market trades (including itself, if the block desk is also a designated institution).
• Obtaining a quote to source the entire trade, often referred to as a “risk market.”

Remember the basics

Consider limit orders rather than market orders to achieve a certain price (though execution is not guaranteed).

Take into consideration the liquidity of the ETF’s underlying securities. Costs incurred by the ETF market maker will increase—and be passed on—if the securities are difficult to trade.

During volatile periods, investors find that market size (the number of shares listed at the best bid and ask prices) and market depth (the number of shares listed at other prices) can have a greater-than-usual effect on spreads and execution quality.

Pay attention to earnings announcements, economic indicator releases, and news from companies that are large constituents of an ETF’s benchmark. ETFs have traded at larger premiums or discounts during market swings, which are often prompted by such news.

Atul Tiwari is managing director of Vanguard Investments Canada.