Dispelling The Myths Surrounding ETF Liquidity

By Shiv Patel , VP, ETF Product Development

When it comes to analyzing an ETF’s liquidity, many often turn to the same measures that is used to analyze a stock’s liquidity (size, spreads, volumes). In doing so, many investors may be deterred from trading an ETF by erroneously deeming it as being “illiquid”, especially for more recently launched ETFs.

An important distinction to make between ETFs and stocks is that shares available to trade of an ETF are not finite. If you set aside buybacks or new share issuances, a stock’s number of shares in the market is generally fixed. By contrast, ETF shares can be created as needed through its unique creation and redemption process. With the help of its liquidity provider partners, this process allows ETFs to increase the shares available in the market in response to increased demand. The combination of this process along with the liquidity of an ETF’s underlying holdings is what constitutes its ‘implied liquidity’, an integral measure that can provide a more holistic view of ETF liquidity.

Implied Liquidity

Implied liquidity refers to the ease with which an ETF can be bought or sold based on the liquidity of its underlying holdings, combined with the ability to create new ETF shares based on demand.

Unlike the traditional liquidity measures which only provide information on how much an ETF has traded (backward looking), implied liquidity sheds light on how much of an ETF can be traded (forward looking). The higher the implied liquidity, the greater the amount of an ETF that can be traded without causing a significant move in its price during order execution. Moreover, implied liquidity can uncover that an ETF can trade far more than what a traditional liquidity measure like Average Daily Trading Volume (ADTV) would suggest.

Beyond Average Trading Volumes

Consider the SPY ETF, one of the most liquid and frequently traded ETFs in the world. Over the last 30 days, it had an ADTV of over 53 million shares per day. While virtually no investor would have any liquidity concerns for an ETF like SPY, looking at the ADTV may not be an accurate depiction of liquidity for all ETFs, particularly for those that focus on more narrow market segments.

Let’s take a look another example to illustrate this. The small cap focused IJR ETF, which represents the stocks within the S&P Small Cap 600 Index, currently has a 30-Day ADTV of about 3 million shares. However, when you look at its implied liquidity, it suggests that IJR comfortably can trade closer to 6 million shares. An investor who is narrowly focused on the average daily volume alone in this example may not want to risk investing in this ETF.

Similarly, the IVE ETF, which represents the stocks within the S&P 500 Value Index, has a 30-Day ADTV of just around 500,000 shares. Implied liquidity, on the other hand, suggests it can trade nearly 46 million shares. We see this dynamic for other areas as well, such as for the MDY ETF which represents S&P MidCap 400 or the IVW ETF which represents S&P 500 Growth Index.

This is all made possible by the ETF creation/redemption process in conjunction with the liquidity of the underlying holdings within these ETFs.

Underlying Liquidity

It’s important to understand that it is not the most liquid holding that dictates the implied liquidity, but rather the least liquid. In other words, an ETF is as only as liquid as its least liquid underlying holding.

To illustrate, let’s look again at the IJR ETF. Its least liquid stock is around 0.09% weight and has a 30-Day ADTV of around 70,000 shares. If an investor wanted to buy a hypothetical 3 million shares of IJR (greater than its 30-Day ADV, and equivalent to about $324 million in dollar value), the trade would require purchasing about $291,000 worth of its least liquid stock ($324 million x 0.09%), or close to 10,000 shares. Knowing this stock trades 70,000 shares daily, would an investor have any liquidity concerns if you asked them to buy 10 thousand shares of it? Likely not, given the stock trades on average seven times that amount daily. Thus, it is important for investors to understand that buying 3 million shares of IJR is not much different than buying 10 thousand shares of the least liquid stock within IJR.

Conclusion

Perhaps one of the most misunderstood aspects of investing with ETFs is the topic of liquidity. Many investors still look at trading volume and incorrectly conclude an ETF’s low trading volumes means low liquidity. An ETF’s liquidity is determined by the liquidity of its underlying holdings. This is measured by implied liquidity and it plays a vital role in judging the overall tradability of an ETF. By understanding and effectively gauging implied liquidity, investors can make more informed decisions regarding their trade execution and risk management.

To learn more about AAM ETFs, contact your financial professional or visit www.aamlive.com/ETF or call us at 1.866.606.7220.

Disclosures

This publication is provided for information purposes only. Unless otherwise stated, all information and opinions contained in this publication were produced by Advisors Asset Management, Inc. (AAM) and other sources believed by AAM to be accurate and reliable. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and best interests. All expressions of opinions are subject to change without notice.

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Investing involves risk, including the possible loss of principal. Shares of any ETF are bought and sold at market price (not NAV) and may trade at a discount or premium to NAV. Shares are not individually redeemable from the Fund and may be only be acquired or redeemed from the fund in creation units. Brokerage commissions will reduce returns. To the extent the Fund utilizes a sampling approach, it may experience tracking error to a greater extent than if the Fund had sought to replicate the Index. Diversification does not assure a profit or protect against a loss in a declining market.

Definitions: Average Daily Trading Volume (ADTV) is a technical indicator that measures the average number of shares of a stock that are traded in a single trading day over a specific period of time, such as a month or year. S&P 500 Index is an unmanaged market capitalization weighted index used to measure 500 companies chosen for market size, liquidity, and industry grouping, among other factors. S&P Small Cap 600 Index covers roughly the small- cap range of US stocks, using a capitalization-weighted index. To be listed on the S&P 600, stocks must have a market cap of $850 million to $3.6 billion. S&P 500 Value Index is a subset of the S&P 500 Index and measures the performance of the large-capitalization value sector in the US equity market. The Index consists of those stocks in the S&P 500 Index exhibiting the strongest value characteristics. S&P MidCap 400 Index measures the performance of mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment. S&P 500 Growth Index measures the performance of the large-capitalization growth sector of the U.S. equity market.

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