Eyes on the Size: A Different Way to Think About ETF Selection

In our interactions with clients and would-be clients, we try to spend as much time as possible learning about their needs, risk appetites and expectations. Of course, we also try to explain how our strategies and solutions might match their requirements.

As we delve into the world of exchange-traded funds (ETFs), it’s clear there are still a lot of misconceptions and misunderstandings about the structure and the role they can fulfil.

A Different View of Size and Liquidity

We often hear ETFs described as the intersection of a stock and a mutual fund: a collection of assets, gathered together like a traditional mutual fund but traded on an exchange like a stock.

While that’s a helpful basic definition for understanding how the structure works, it can also cause some confusion when assessing an ETF, particularly in considerations of size and liquidity (or volume traded).

We appreciate that compliance officers and certain risk departments look at size—that is, assets in the fund and trading volume. Our argument is investors are screening ETFs with the wrong metrics. They’re using archaic measures that have been appropriate for active mutual funds, but which are less suited to ETFs.

In dealing with investors, we’ve found that many express a preference for buying larger funds. When we ask why, the answer is often: “Because of liquidity”. The thinking is that bigger is always better.  That is, ETFs with high average daily volumes are perceived to be more liquid—more people are regularly trading it.

It certainly makes sense, right? Investors want to be able to easily buy into a fund and then just as easily sell their position when they want to.  Some are concerned that if they own more than 50% of the total assets of an ETF, that might affect its liquidity because there are fewer people to trade with.

We think that way of thinking reflects the problem that clients are wrongly applying mutual fund screening criteria to ETFs.

An ETF may trade like a stock, but it is really just a wrapper into a pool of securities and that pool has larger depths of liquidity than it might seem on the surface. ETFs actually have two sources of liquidity: the ETF itself, and the underlying basket of securities on which it is based.

Dual Layers of Liquidity

An ETF’s stock-like characteristics can prompt some misconceptions, but it can be equally confusing to think of an ETF in exactly the same way as a traditional mutual fund.

Active mutual funds generally have a fund manager with the discretion to pursue a strategy. He or she has the freedom to implement that strategy, and as a result, an investor doesn’t typically know beforehand how that strategy will manifest itself.

In those circumstances, before deciding to invest, it’s natural that a would-be investor would want to look for a three-year or longer track record, and/or sizeable assets under management (AUM), which he or she might view as an indicator of wider confidence in the strategy.

In recent days, we’ve had an example in the United Kingdom whereas an actively managed property fund experienced a liquidity freeze—investors couldn’t get their money out. These types of scary situations have also given ETF investors pause, thinking they won’t be able to get their money out when they need to, either—particularly in a smaller ETF.

However, it’s important to remember that an ETF is an index product that is systematic and rules-based, so investors are ultimately engaging not just with one product, but with a pool of securities.

Investors have the option to offer their ETF units to another investor in a so-called secondary market trade. But what if there are no willing buyers? That’s where the structure of ETFs makes a difference: One of the central characteristics of an ETF is that the supply of shares is flexible.

Should there be no willing buyers, an ETF investor will be able to sell to authorised participants (AP) and/or market makers, whose job it is to step in and trade—to provide liquidity. We explained their respective roles in detail in a previous article.

For example, an investor wanting exposure to stocks with high market capitalisations decides to invest in an equity ETF whose underlying index is comprised of large and recognised names, the “blue-chip” stocks. Those individual blue-chip stocks typically trade very large volumes every day, even if the ETF itself doesn’t trade that much. So, if the underlying basket is liquid, it would follow that one shouldn’t have issues trading the ETF, even if the ETF itself only trades a few shares per day.

An Indicator That’s Not a Cause of Illiquidity

We’ve explored how liquidity in underlying stocks impacts equity-based ETFs—how strong liquidity in the underlying securities should mean ample liquidity in the related ETF, even if it’s a new or smaller ETF.

In the fixed income space, however, there is an interesting additional nuance. An ETF can actually be an indicator of the liquidity of the underlying bond market. After issuance in the primary market, stocks trade in a secondary market—that is, a centralised exchange.

Instead, bonds are traded in what’s known as the “over-the-counter” market—which involves a direct execution between the parties. Because bonds are not listed on a centralised exchange, pricing is typically a bit opaque. As a result, an investor wanting to see how their traditional bond portfolio is trading needs quite sophisticated data feeds to locate the pricing of the underlying securities.  A fixed income ETF actually takes that opaque market and puts it on a centralised exchange, feeding live two-way prices.

If there’s volatility in the underlying market, of course that will be reflected in the spread the ETF is trading at—that is, the difference between the price to buy and the price to sell. Without ETF pricing, fixed income investors might not realise there were issues in the underlying market.

In this way, ETFs have actually democratised price discovery and democratised the ability for investors to buy and sell the underlying market.

So in sum, there’s more to deciding how or when to trade an ETF than size—and more to the notion of liquidity than meets the eye.

View Jason Xavier’s previous articles here. 

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The comments, opinions and analyses are the personal views expressed by the investment managers and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.