From the April 2011 issue of Investment Advisor • Subscribe!

April 1, 2011

ETFs and Liquidity: A Primer

Advisors, institutions and retail investors have had certain notions on the ability to execute an optimal trade based on the perceived liquidity of specific exchange-traded funds (ETFs). However, what has been used to determine a stock’s liquidity can’t be applied to ETFs.

Attributes such as trading volume and assets used to be major considerations for investors because it tended to be that low activity in a fund led to wide spreads, bigger costs and, in a worst-case scenario, no one to buy the fund you’re holding when you’re in the market to sell it.

If you’re an advisor concerned about liquidity in low-volume ETFs, you’re not helpless. Among your options is using the services of alternate liquidity providers.

The providers facilitate the process of trading ETFs by providing a market for even the most thinly-traded fund, and they’re opening up new worlds for advisors and investors, making it possible for them to invest in ETFs that they once feared would be illiquid. The services of liquidity providers give advisors better access to price discovery and execution.

Paul Weisbruch, vice president of ETF/options sales and trading at Street One Financial, provides some answers on liquidity commonly seen with ETFs.

How is the liquidity of an ETF determined?
ETF liquidity is reflected by the overall liquidity of securities in the underlying benchmark that the ETF tracks. Basically, “ETF liquidity has everything to do with ‘what is inside the index, or basket’ that the ETF is based upon and has very little to do with the daily volume in the product.”

It is a common misconception that ETFs with high trading volumes are liquid while those with low trading volumes are deemed illiquid. Street One defines liquidity in terms of “price impact of entering or exiting a position.”

For instance, in examining SPDR S&P 500 (NYSEArca: SPY), iShares S&P 500 Index (NYSEArca: IVV), Rydex S&P Equal Weight (NYSEArca: RSP) and RevenueShares Large Cap (RWL), the four equity products are all based on the S&P 500, with SPY and IVV weighted by market capitalization, RSP using an equal-weighted methodology, and RWL being revenue-weighted. Overlooking the fact that the ETFs trade at varying levels of volume, these four ETFs hold a basket that are identical name for name.

If traded properly, buy and sell orders should have around the same price impact in percentage terms in all of the above products, although bid/ask spreads will be wider from one ETF to another. But with that said, no one said you have to trade with the visible bid/ask spreads.

How does the structure of an ETF affect liquidity?
ETFs were created with an innate creation/redemption process, but Weisbruch points out that many financial advisors and institutions that Street One deals with may confuse the process when speaking in terms of “doing a creation unit” or “redemption unit,” which is not exactly how a trade execution process works.

The basic designs of an ETF allow investors to trade intraday, and if executed properly, they can enter or exit large positions with negligible price impact in terms of the underlying basket.

ETFs generally reflect their true underlying value, which makes them transparent and a more attractive investment for investors who aren’t content with closed-ended funds’ inherent discount/premium issues.

What should an advisor do if they have liquidity concerns?
Weisbruch vehemently urges advisors to never use market orders, regardless of what type of ETF they are planning to trade, or whether the ETF is heavily traded or one that trades lightly. Market orders may hurt a portfolio’s performance due to lost basis points on trades.

Limit orders are better alternatives, but there is a risk that an order won’t be filled. Weisbruch suggests contacting a trading desk for orders of 5,000 shares or more. “It pays from an advisor’s standpoint to make sure that the desk they are executing with truly understands ETF pricing nuances, and do not trade ETFs like they are closed-end funds of stocks, as it is fairly common for a general trading desk to be unfamiliar with ETF trade execution.”  

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