Exchange-Traded Funds: Back to the Basics on Liquidity

by Jason Xavier, Franklin Templeton Investments

Fall is traditionally back to school season, and in that spirit, Jason Xavier, Head of EMEA ETF Capital Markets, goes back to the basics. He reminds us about the ins and outs of ETF liquidity and dispels the myths many still have.

For many across Europe and North America, the months of September and October mark the return to school and university. Given what we’ve all been through over the past year and a half, many are hoping that the 2021/22 academic year will be an uninterrupted one!

It’s been a while since I last penned my thoughts about the exchange-traded funds (ETF) ecosystem and in particular ETF liquidity; however, recent conversations with a whole new wave of ETF adopters prompted my motivation to remind us all about this valuable attribute that ETFs provide.

Let’s remind ourselves of the basics. I am admittedly biased, but I think ETFs take the best attributes of both mutual funds and individual stocks: trading in the primary market like a mutual fund and offering secondary market liquidity just like a stock. Understanding the mechanics behind this structure helps highlight the benefits that many investors utilise in managing their investment objectives.

Understanding ETF Liquidity  

Alongside all my industry capital markets counterparts, the most used quote in our day-to-day role must be “the liquidity of the ETF is a function of the underlying.” And rightly so. As more and more investors turn to using ETFs, understanding and appreciating an ETF’s liquidity and appreciating the true liquidity is important. Let’s remind ourselves of the mechanics and dispel the myths many still anchor to.

As a refresher, an ETF’s underlying value is derived from the price of the underlying securities it invests in. In other words, the price of the underlying basket/index constituents it tracks. As such, many investors believe the underlying liquidity of an ETF is related to volumes traded. However, that’s not the full picture. ETF volumes tell you only what has traded, not what could be traded. To see what could be traded, an investor has to look through to the underlying stocks at the individual constituents. An ETF is an open-ended fund that can issue more shares based on demand—and can terminate shares based on redemptions.

Going back to the idea that ETFs offer the best of both mutual funds and stocks, unlike a mutual fund, an ETF doesn’t need a minimum initial client investment to stay open or be liquid. A newly launched ETF will typically have much lower average daily trading volumes than more established or older funds. In addition, newer ETFs tend to have far fewer shareholders—on the first day of trading it’s not uncommon for there to be just one. But we don’t think that’s a reason to avoid a new ETF, as a new ETF’s price will generally remain in line with the price of the underlying basket of securities.

Additionally, many still wrongly apply a mutual fund screening criteria and in particular the size of an ETF as an indicator of liquidity, especially when assessing the risks around selling and exiting a position. They will say something like, “we prefer to invest in larger funds to ensure we have no liquidity issues should we need to liquidate our position in stressed markets.” Investors need to fully appreciate that an ETF is effectively just a wrapper, giving access to a deep and liquid pool of underlying constituents, like a blue chip large-capitalisation equity index, which should illustrate the vast and deep liquidity on offer.

While the underlying liquidity of a single stock is a function of the finite number of shares outstanding, the underlying liquidity of an ETF is unrelated to volumes traded. ETF volumes tell you only what has traded, not what could be traded. To see what could be traded, an investor has to look through to the underlying stocks at the individual constituents.

So, when it comes to liquidity, the size of an ETF is only academic.

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.

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This post was first published at the official blog of Franklin Templeton Investments.