Liquidity, or the perceived lack of, in the exchange-traded fund (ETF) space can often make investors think twice before putting their money into the passive products.
This has become an important issue more recently with the growth of passive fixed income products, as some investors have begun to anticipate an end to the multi-decade bond bull-run.
Source: Vanguard
However, ETF liquidity issues may have been overstated and misunderstood by investors.
“Liquidity is an important consideration when considering any investment option and ETFs are no exception,” explained Tom Stephens, head of international ETF capital markets at JP Morgan Asset Management.
Yet, in some cases, said Stephens, there may be even greater liquidity than in some areas of the supposedly more liquid equity markets.
But first, investors need to understand the inner workings of the ETF market, he said.
“To fully understand ETF liquidity, one must examine the mechanism of the ecosystem,” he explained. “ETF shares are created by professional investors known as authorised participants, or APs.
“APs place an order directly with the ETF manager [in the primary market] and in exchange for in-kind or cash payment, they receive ETF shares, which can them be sold by the AP in the secondary market.”
And it is here where the first doubts about illiquidity arise. Some investors assume that because the primary market is reserved for APs – who are responsible for the ‘creation and redemption’ of shares in the secondary market – liquidity can be constrained.
However, retail investors will often be able to buy and sell into the secondary market more easily than larger investors because there is more liquidity than they realise.
Another way that investors can misidentify liquidity issues is by placing too much importance on ETF assets or trading volumes.
“Some investors may be sceptical that small or low-trading volume ETFs can be highly illiquid, but in reality, they may not be because of the significant amount of ‘hidden’ liquidity out there,” said Stephens. “Liquidity is not just what you see on the screen.”
Unlike individual stocks and close-ended funds, which have a fixed number of shares available on the secondary market, ETFs are open-ended investment vehicles with new shares issued to meet demand.
Instead, investors should look through to the ETF’s underlying securities to assess overall liquidity.
Where liquidity concerns are enough to cause big swings in prices there are some ways that investors can protect themselves.
One is by setting ‘limit orders’, said Stephens: an order to buy or sell a set number of shares at a specified price or better.
In contrast a ‘market order’ to buy or sell immediately at the best available current price could end up being executed at a price far higher or lower than expected by the investor, the so-called bid-ask spread.
This spread is another concern highlighted by the Vanguard European survey, with 21 per cent of respondents from the UK ranking it among their top-three issues when selecting an ETF.
By setting a limit order – an order to buy or sell a set number of shares at a specified price or better –investors can gain some control over the price at which the trade is executed.
Another issue that investors worry about in relation to liquidity is the time of day when placing a trade.
Stephens said that time of day that a trade is placed can be an issue for investors and that they should avoid trading at the open or close of business or when a significant portion of an internationally invested ETF’s underlying markets are closed.
The beginning and end of a trading day can be more volatile than at other times leading to wider bid-ask spread.