CONTRIBUTORS
Bobby Eng
Senior Vice-President, Head of Platform and Institutional ETF Distribution
One of the most common misconceptions about ETFs is mistaking trading volume for liquidity. ETF trading volume is NOT equal to ETF liquidity. This is a crucial concept to understand when analyzing ETFs and perhaps one of the most critical considerations when assessing an ETF investment. Compared to some of the longer standing ETFs in the market, many ETFs are not as actively traded and have lower assets under management (AUM). This may cause investors to look elsewhere, as they believe the liquidity in the ETF is not sufficient to trade, but this could not be further from the truth.
ETFs are at least as liquid as their underlying basket of securities. There is a more comprehensive way to measure how liquid an ETF is than simply looking at the average daily volume of the ETF itself, and that’s implied liquidity.
With ETFs, implied liquidity is forward-looking, whereas trading volume is backwards-looking. Implied liquidity provides an indication of how much of an ETF can be traded in the future, while trading volume looks at only how much was traded in the past. It evaluates the liquidity of the underlying holdings of the ETF and how many ETF shares can be traded without a bigger cost impact. What determines the liquidity of an ETF is the liquidity of underlying securities; derivatives based on the ETF; and different trading vehicles, such as similar ETFs, swaps, futures, options and structured products.
As an example, let’s look at Franklin FTSE United Kingdom ETF (FLGB) to see how large a trade size can be executed without impacting the fund. The 90-day average aggregate volume is roughly 200k shares; however, the implied liquidity is almost 45 million shares or $1.14B dollars as shown in Figure 1 and 2. We can see that on October 26, 2021, a block trade of 10,949,261 shares traded at $25.82. That is more than 55 times the average daily volume (ADV) as shown in Figure 3. The client who initiated this trade was able to work with an ETF liquidity provider who had the ability to access other sources of liquidity to facilitate the block trade. Investors may sometimes rule out an ETF because it doesn’t meet certain average daily volume (ADV) levels, but this could eliminate hundreds of ETFs from consideration that could have potentially been effective and impactful investment vehicles. ETFs with lower ADV can execute in large size with minimal market impact by working with a liquidity provider. This is the power of implied liquidity!
Figure 1
Figure 2
Figure 3
(All Bloomberg illustrations are as of Nov 9, 2021)
It is critical to understand that the liquidity of an ETF is a function of a much greater group of variables than just the historical trading volume; instead, core liquidity is based on the underlying basket which the ETF represents. This is especially important for relatively newly issued ETFs that may appear to have low liquidity as measured by trading volume or even by the exchange bids and offers, but they can have massive liquidity supported through the ETF creation and redemption process.