The True Liquidity of ETFs: Implied Liquidity

Bobby Eng CIMA®

Bobby Eng CIMA®
Senior Vice President,
Head of Platform and Institutional ETF Distribution

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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 a 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 only looks at 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 are 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 it 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

Bloomberg Illustration 1

Figure 2

Bloomberg Illustration 2

Figure 3

Bloomberg Illustration 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.

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What Are the Risks?

Commissions, management fees and expenses may all be associated with investments in ETFs. Investors should carefully consider an ETF’s investment objectives and strategies, risks, fees and expenses before investing. The prospectus and ETF facts contain this and other information. Please read the prospectus and ETF facts carefully before investing. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. Performance of an ETF may vary significantly from the performance of an index, as a result of transaction costs, expenses and other factors. The indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any security holder that would have reduced returns. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

Bobby Eng’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.