By Bill Chambers, Vice President and General Manager of Wealth Solutions, Interactive Data.

Money managers certainly know the importance of gauging an ETF’s liquidity. In a Greenwich Associates survey of institutional managers last year 83% of them identified “liquidity/trading volume” as their top selection criterion for ETFs. Liquidity was mentioned more than an ETF’s expense ratio (74%) or it’s tracking error (72%).

Bill Chambers, Vice President and General Manager of Wealth Solutions, Interactive Data.

Why is that?

Well the first element for consideration is that not many ETFs trade every day or in very large amounts. In fact over 75% of the 1,448 exchange-traded products listed on US exchanges have average dollar volume below $150,000^*. So if ETF volume is your biggest selection criteria your choices start getting pretty slim.

In reality, investors have to go beyond just looking at the trading volume. And by looking more closely at some ETFs investors may find better ways to get into certain markets. For example, some firms will trade some low-volume international ETFs, where there are sizeable constituents within those ETFs that make it palatable.

But how do the constituents of an ETF affect its liquidity? What other influencers are there?

Going deeper

As it turns out there are several things that can influence an ETF’s liquidity. While not an exhaustive list, here are some of the key market dynamics to consider.

ETF volume – It seems to be apparent that an ETF’s volume is a key driver of its liquidity. Just look at the ten most actively traded ETFs and their bid/ask spreads^** in the table below. It’s a pretty diversified group of ETFs and yet they all trade with spreads right at the market or just a penny wide.

Source: Interactive Data, as of 4/1/2013.

Plotting all this on a chart and adding in the ETF’s premiums and discounts for good measure you can observe how they all cluster around a tight band showing very efficient market pricing. Volume most certainly does wonders for an ETF.

Two-sided markets – To have good liquidity any security should maintain a healthy balance of volume from both buyers and sellers and ETFs are no exception. For example if an ETF’s trading volume is coming primarily from the buyer’s side of the market it may cost a market maker more to fill their sell orders. To compensate for their added costs and risks market makers may widen their spreads on the ETF. So looking at the size (number of shares) of the bids and asks to see where most of the volume is coming from can provide improved insight into an ETF’s liquidity. Also looking beyond level 1 quotes to see the bids and asks that were put out there but not taken (traded) can shed light on how balanced the market demand is for an ETF.

ETF options – Many ETFs have options trading on them and market makers can use the options to help them hedge their risk when they have to take a large position on a particular ETF. If an ETF is not covered well in the options market the market maker can’t hedge their risk as well which may cause them to widen their spread.

Index futures – If an ETF doesn’t have a lot of options trading on it the market maker can choose to hedge against the ETF’s benchmark index instead using index futures (assuming the index is widely covered in the futures market).

You may have already ascertained from these first four market dynamics why some ETFs trade with very thin spreads. For example the S&P 500 is the most covered index in the world. Subsequently a market maker covering ETFs that track the S&P 500 index often sees:

1) High ETF volume
2) Balanced demand from buyers and sellers
3) Options available on the ETF
4) Futures available on the index

Given these dynamics it’s no wonder some of the S&P 500 ETFs trade at the market.

Unfortunately not all ETFs have all four of these elements working for them. Once you get beyond broad US indexes creating liquidity takes a little more work. That brings us to one of the most critical mechanisms facilitating ETF liquidity; the creation/redemption process.

ETF creation/redemption – Alarm bells ring (so to speak) on institutional trading desks when an ETF’s price moves above or below the value of its constituents. And the subsequent trading activity from those desks helps create liquidity and keep an ETF’s price in line with the value of its constituents.

ETFs have a unique creation mechanism which can allow large trading firms (authorized by the ETF issuer) to swap an ETF’s constituents with the ETF issuer in exchange for the corresponding number of shares of the ETF^***. The trading firm makes a profit because they are trading the “cheaper” constituents in exchange for the “higher priced” ETF shares instead of buying the ETF on the stock exchange.

They can do the reverse as well and give the ETF issuer back the shares of the ETF (i.e., redeeming them) in exchange for the ETF’s constituents. So if an ETF price moves below the value of its constituents the trading firms can profit the other way.

By providing the capital markets with an additional source of ETF shares (and the profit motivation to use it) the creation/redemption process provides an additional source of liquidity for the ETFs. The availability of the creation/redemption process also keeps ETF prices in check with their underlying constituents. For example, if one authorized trader is selling an ETF low (basically mispricing it) another authorized trader may buy it because they can redeem the ETF shares directly to the ETF issuer at the higher price and make a profit.  Eventually, it is quite possible that the authorized trader selling the ETF low will realize their mistake and bring their price back up when their own creation/redemption calculations shows they are selling the ETF for less than the cost of creating it.

ETF creations and redemptions can only be done in large block trades, typically a minimum 50,000 shares so there can be a lot of money at stake. The ETF issuer also charges the trading firm a fee for the issuer to create new shares. Many institutional traders have real-time models and trading algorithms that constantly measure the cost of an ETF’s creation versus the ETF’s price and the value of the underlying constituents. These models can help the traders move in quickly to make a profit, which in turn can add liquidity to the market and help keep the ETF’s price stay fair to its underlying constituents.

Knowledge is good

Knowing more about the different dynamics of an ETF’s liquidity can help advisors as they identify investment opportunities for clients, manage their execution costs in terms of bid/ask spreads, and maintain their clients’ confidence in their ETF selections. Good thing too because the more clients learn about ETFs the more they ask their investment advisor about their liquidity.

References:
*Based on 30-day average dollar volume for US listed ETPs as of 3/22/13. Source: Interactive Data.
**Bid/ask spread: The difference between the highest price a buyer will pay for the ETF and the lowest price a seller will accept.
***The process is called an ETF “creation” because the ETF issuer has to create shares of the ETF to give to the trading firm.

This article is provided for information purposes only.  Nothing herein should be construed as legal or other professional advice or be relied upon as such. © Interactive Data Ltd 2013