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Determining the Liquidity of an ETF

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Determining the Liquidity of an ETF

Does Volume Really Matter?

Underlying liquidity will begin to tell the story of how liquid an ETF could be, no matter what the average daily volume (ADV). But how do you measure that liquidity? For equity-based ETFs, a first step is to examine the top 10 holdings to see if they are “household” names. If they are not, you may want to investigate further, utilizing a tool such as Bloomberg’s implied liquidity field listing. For fixed income or derivative-based ETFs, call the sponsor and speak to someone on the capital markets team, call your block desk or reach out to a liquidity provider and ask what would happen if you traded X amount of shares. 

What Factors Determine the Liquidity of an ETF?

Is it how many shares can be bought at the ask price or sold at the bid price? Is it the average daily volume over a certain time period? Or the liquidity of the underlying securities? Understanding what creates liquidity in an ETF will help guide advisors to the best possible execution method for a given ETF trade. Let’s explore what makes an ETF liquid and, specifically, whether there should be a concern in trading an ETF with a lower average daily volume (ADV). 

Understanding an ETF’s Open-Ended Structure

First of all, it is critical to understand that ETFs trade quite differently than stocks and other investments that are traded on an exchange (e.g., options or closed end funds). While they do have an open-ended structure, shares can be added or subtracted at any time through a process called creation/redemption. In a creation transaction, an authorized participant (AP) – a market maker or a large trading firm that handles all aspects of client activity itself – assembles a portfolio or basket of securities that comprises the ETF unit. Typically, the portfolio involves 50,000 or 100,000 shares as determined by the ETF sponsor. The AP then turns the basket over to an ETF distributor and a custodian. In exchange for the basket of securities, the ETF custodian provides shares of the ETF to the AP at the net asset value. In a redemption transaction, the process works in reverse.

This structural process allows ETFs to trade at or near what is perceived as fair value. If the ETF was priced incorrectly, trading firms could take advantage of the arbitrage mechanism, which would ultimately move the price back in line with its fair value. 

Average Daily Volume (ADV) is Only Part of the Picture

The secondary market is where all investors can trade. When pulling up a quote on a proprietary system or through a financial website, the secondary market is what you see. The components of such quotes are usually the last trade, the bid price and ask price (the spread), the number of shares that can be sold or bought at each price point and the volume of shares traded so far that day. A common misconception holds that to get best execution an ETF must possess significant average daily trading volume. But onscreen volume isn’t a proxy for ETF liquidity. That’s because executed share volume pertains only to the secondary market exchanges on which the ETFs trade.1 It is only an indication of what has traded, not what could trade. What can’t be seen in a normal quote system (unless it is a paid subscription system) is market depth, meaning all the quotes behind the inside quote that can add to the liquidity of an ETF.

The Most Important Consideration: The Liquidity of the Underlying Securities

Another driver of liquidity that is not readily apparent is the actual liquidity of the underlying securities within the ETF itself. Underlying liquidity will begin to tell the story of how liquid an ETF could be, no matter what the ADV. But how do you measure that liquidity? Different types of ETFs are going to be more liquid than others. For example, large cap U.S. equity funds will be much more liquid than emerging market bonds. A simple first step is to examine the top 10 holdings. If the major holdings are “household” names in their categories, this may provide you with a good starting point for further analysis. You may also want to investigate further, utilizing a tool such as Bloomberg’s implied liquidity field. This field basically estimates how many shares you can trade before you begin to potentially impact the price.

Be Skeptical

In creating a customized due diligence process, advisors must take care to avoid some of the most common misconceptions. Following are three key considerations.

Hypothetical ETF Liquidity Example
30-day Average Daily Volume: 15,820
Bloomberg Implied Liquidity Number 3.4 million shares
Top 10 Holdings 

At first glance, the historical volume in the hypothetical example above (15,820), may lead you to think that it is not a very liquid ETF. By analyzing both the fund’s top 10 holdings and reviewing the implied liquidity, you can see that an investor could potentially trade roughly 3.4 million shares (see Table 1 below) before having an impact on the price.

However, keep in mind there are times when an incorrect security shows up in the calculation, which can skew the number. That’s why it is important to look at more than one metric to see if an ETF is liquid.

Below is the implied liquidity table for all FlexShares equity based ETFs:

On the surface, ETFs that have low volume may appear to be less liquidity, but that may not always be the case. Though it may take a little more time to trade a lower volume ETF, taking the time to evaluate all of your possible options may help to differentiate you from others who don’t want to put the time and energy into understanding how to achieve best execution.

The Exception: Fixed Income ETFs

The downside to looking at the top 10 holdings or the implied liquidity number is that it only works for equity based ETFs. The liquidity of fixed income or derivative-based ETFs is a little more difficult to gauge and implied liquidity is not calculated for fixed income or futures based ETFs. When it comes to fixed income ETFs, it is even more critical to understand the liquidity of the underlying securities. As an example, let’s look at the ultra-short market since this category does not invest in government securities as its primary goal. Many investors would think that these securities are very liquid and easy to buy because they are traded more frequently or they mature faster. However, that is not always the case. Another misconception is that these securities have a very tight trading spread. Again, that is not usually the case. There are several ways to figure out the liquidity of a fixed income or derivative-based ETF.

  • Call the sponsor and speak to someone on the capital markets team.
  • Call your block desk.
  • Reach out to a liquidity provider and ask what would happen if you traded X amount of shares.
     

FLEXSHARES CAN HELP: Our Capital Markets team offers expertise to help you trade in a cost-efficient manner. We can provide you with insights, answer questions and recommend trading strategies. Learn more here.

 

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