Feb 20, 2015

In the volatile (and growing) world of todays equity markets, ETFs which provide access to specific segments of Indian or Global markets are an attractive proposition. However, as a first time buyer looks at traded volumes, they may conclude that the there is a possibility they may have to buy at premiums (expensive) or redeem at discounts. So how should one really analyse the suitability of an ETF from a liquidity perspective?

Note: The subject is equally relevant for Institutional investors as it is for retail. In India, institutional investors can directly access the underlying index liquidity and create/redeem ETF shares with with the issuer. While this may need the investor to go off the screen, the cost advantages make it an attractive option.

ETF liquidity is a much studied subject, but is most often misunderstood, even though it is fairly straight forward. However, there are two aspects which are worth mentioning, one is the sources of liquidity and the other is the measure of liquidity.

The Myth. The first myth to dispel is that an ETFs liquidity is its average trading volume on the stock exchange. A common assumption is that an ETFs liquidity is determined by its trading volume, but that isnt necessarily so. The trading volume is more of an indicator of a funds popularity and how much it traded in the past not how liquid it is. A better gauge of liquidity is to look at the hypothetical number of shares that can be traded. An underlying stock in the ETF with low trading volumes will adversely affect the liquidity irrespective of the actual traded volumes of the ETF units i.e. an in-demand ETF could be often traded and still have low liquidity as that low individual stock liquidity will limit basket creation/redemption. Conversely, a thinly traded ETF can be very liquid as the underlying stocks may be very liquid. Therefore it can be said that the true measure of ETF liquidity is the liquidity in the underlying basket.

Liquidity Illustration: Lets say that we wanted to invest in an ETF that traded over 1 million share volume per day. At first glance, we would consider it a highly liquid ETF. However, lets assume that this ETF included 5 very liquid large cap stocks and one very illiquid small cap. If suddenly a large investor wanted to buy in and the ETF basket called for a large number of shares to be created one day, the small cap may not trade at high enough volume to be included. This could prevent additional units of the ETF from being created in its original basket form. This example serves to illustrate a scenario where the volume traded of the ETF itself is not as issue; rather it is the thinly traded nature of the underlying stock that poses the problem.

Sources: Therefore, going back to the mechanics of the ETF — liquidity (or the ability to buy or sell) — has two sources: the creation and redemption by authorized participants and the market making activities of broker dealers given that all ETF units can be bought/sold (created/redeemed) from all of these three sources, notwithstanding the dark-pool that exists at the market maker/broker-dealer level. The creation, redemption of ETF units (in kind) is largely dependent on market demand for that specific exposure or temporary arbitrage opportunity (either a premium or discount).

An Example: A large brokerage house receives a bulk order from a client for ETF units. The brokerage, now acting as an Authorised Participant, buys the underlying basket instead of going to the market for those ETF shares. This is converted into ETF shares by the AMC thereby infusing a large number of shares additionally in to the market.

On the reverse requirement, the same Authorised Participant could redeem the units and take delivery of underlying basket and then smart route it to the market thus providing an additional avenue for selling the ETF unit.

This activity has the additional advantage of aligning the price and the NAV of the ETF as the premium/discount to the NAV is clearly visible to all market participants.

How would a financial advisor avoid paying large bid-ask spreads and advance their use of ETFs without getting hindered with the apparent trading volumes? Using limit orders or accessing upstairs liquidity providers for large trades can lead to a better execution.

Conclusion

Investing in an Exchange Traded Fund, unlike a share, provides liquidity by secondary market trading as well as through the unit creation / redemption process. The former is measured by trading volumes and the latter is virtually unlimited for creation and limited to the AUM for redemption. All of these activities have the effect of matching demand and supply thereby catering to all sizes of investor orders. Trading volumes therefore have little bearing on the liquidity of an ETF.