Rather than focusing solely on trading volumes, says Zach Hascoe, investors and their advisers should look for ETF products that provide strategic and investment opportunities for their portfolios
Liquidity is one of the most misunderstood terms in the exchange-traded fund (ETF) world. So what is it really? In general, it is defined as the ability to quickly convert an investment into cash with as little transaction cost or ‘friction' as possible.
Intra-day liquidity is one of the most important factors separating mutual funds from ETFs. And because ETFs, like stocks, are traded on exchange, investors often equate volume with liquidity. This would be a mistake. The liquidity of an ETF is not defined by the volume it trades on a given day and is not indicative of the potential future liquidity of an ETF. ETF volume is a historical number.
In addition, assets under management are not indicative of the potential liquidity of an ETF. To put it simply, ETF liquidity is a function of the accessibility of the assets in the underlying basket with an additional layer of liquidity provided by daily trading volume of the ETF on exchange.
ETFs are open-ended vehicles, which means new shares can be created and redeemed on demand. Since ETFs are listed on major stock exchanges - the secondary market - but also have a robust primary market process for creation and redemption, investors can trade these ETFs intra-day, very efficiently, regardless of the daily volume of the ETF.
New shares will be created on the primary market to fulfil demand on the secondary market. First and foremost, an ETF is a wrapper that holds a basket of underlying securities or provides exposure to an underlying benchmark. The liquidity of an ETF, therefore, is derived primarily from this underlying basket of securities.
Investors should not rule out innovative and valuable strategies based on ETF volume or assets under management - although it is worth bearing in mind a couple of traps investors may fall into.
One trap is thinking all ETFs behave similarly and are best used in the same way. This is important because strategic investment products tend to have lower daily volumes over tactical ones. Investors using strategic ETFs are typically making longer-term investments. These ETFs typically do not track the main benchmarks but, rather, proprietary indices positioned to help investors achieve better risk-adjusted returns over time.
These products are more likely to have lower daily ETF volumes as investors in them are not buying and selling very often. Again, this does not mean the product is illiquid, but rather that it trades infrequently on exchange. The liquidity will come from the underlying basket and is aided by the structural efficiencies of the ETF wrapper. These strategies should not be omitted from an investment universe based on volume metrics.
Another trap is using the US markets as a benchmark for comparison for Europe. The reality is the European ETF market is very different. It is a lot more fragmented than the US one - there are a number of issuers across many countries launching and listing products on different exchanges and in different currencies. The same ETF can then be cross-listed four times and also listed in four currencies. ETF volumes do not consolidate on one exchange or one ticker, unlike the US where ETFs are listed and settled in US dollars and a consolidated volume number is published.
It is also well-known that off-exchange or over-the-counter trading is much higher in Europe than in the US. This is unfortunate from a customer perspective, because they obscure the view of what is actually going on in the markets. So far this year, according to London Stock Exchange (LSE) data, some 75% of all ETF trading on the LSE occurred over-the-counter. These volumes do not necessarily hit the exchange in the printed volume figures, which leads to a distorted market view. In this case, ETF volumes are not actually low - they just look like they are.
Quantifying underlying liquidity
So how can an investor actually quantify the underlying liquidity of an ETF? The ‘ETF implied liquidity' metric is the only way for investors to gain an understanding of the potential liquidity of an ETF. Implied liquidity is defined as "a representation of how many shares can potentially be traded daily in an ETF as portrayed by the creation unit". This number helps investors understand, in a tangible way, how many shares - or US dollars, euros, pounds or Swiss francs - of an ETF they can trade on a daily basis without having a price impact on the underlying securities.
In the illustration below, you can see the WisdomTree US Equity Income UCITS ETF (DHSD LN) implied liquidity is more than $1bn (£800m) - over 58 million shares. This indicates to an investor that, without having a price impact on any of the underlying securities, you can still easily trade more than $1bn of DHSD LN on a daily basis when looking at the liquidity of the underlying securities and extrapolating that into ETF terms. This presents a very different understanding of potential use of the ETF than is presented from the actual trading volume of the ETF on exchange.
In addition to understanding implied liquidity, you should also ask some questions of the ETF issuer's capital markets team in order to understand the potential investment size that can be made in an ETF - for example:
* How liquid and accessible are the actual underlying securities?
* How easy is the underlying basket to hedge?
* Are there correlated hedges?
* Are there correlated derivatives or products that can be used to provide liquidity in the ETF?
* Are there taxes or ticket charges applied in trading the underlying securities?
As the ETF industry continues to grow, there will be new innovative products brought to market. Most will not enter the market on Day 1 with large assets under management or volume but savvy investors should look for those products that provide opportunities for their portfolios - those ETFs that resonate with strategy, which fill an investment need - rather than looking solely at trading volume.
Ultimately, ETFs as a structure are robust and transparent with the advantage of being able to move in and out of positions quickly and efficiently when need be - thanks to the efficient features of the structure and of the ETF trading process.
Zach Hascoe is director of capital markets at WisdomTree
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