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The exchange-traded fund (ETF) is increasingly seen as the dominant investment wrapper. In fact, there are now more ETFs available than stocks available for trade.
As ETFs take over more of the market share and investor interest grows, ETF liquidity must be factored into investment strategies to ensure successful outcomes. Here are the factors that impact ETF liquidity, including what every asset manager should know about them in order to help their clients achieve their investment goals.
Liquidity is mainly determined by the liquidity of the underlying assets of a particular fund, as well as the trading activity in secondary markets.
This means an ETF’s liquidity can be affected by the index it tracks. Well-known indexes like the S&P 500, the NASDAQ 100, and the Dow Jones Industrial Average often have more liquid underlying assets, which in turn gives ETFs that track those indexes more liquidity.
The opposite is also true: If an ETF tracks an index that is less liquid, it can reduce liquidity and make trading that ETF more difficult. A complicating factor in this is that ETFs have an open-ended structure that makes the creation and redemption process of ETF shares innately more liquid beyond what investors can determine from looking at the secondary market.
Market makers can increase ETF liquidity by narrowing bid-ask spreads and making ETF trading easier on the secondary market.
However, the current market conditions have created a unique scenario. Asset managers who want to keep their ETFs ahead of the market must update their liquidity assessment approaches.
Some things to keep in mind:
Regional conflicts can affect worldwide ETF trading patterns. When the United States was in a position of global leadership, there was a certain degree of order that could be relied upon even as conflicts broke out. With the U.S. withdrawing from the global stage, there is less of a backstop.
Sanctions and trade restrictions create overnight liquidity constraints. In prior decades, it was easier to determine which nations might be sanctioned. Some countries can get away with substandard policies and suffer minimal international rebuke, while other countries could be slapped with sanctions despite minimal offense. In other words, supply chains and commodity ETF liquidity have become highly unpredictable.
Currency restrictions are also disrupting international ETF arbitrage. As the world begins to move away from the U.S. dollar, that could also further sap the global leverage of the U.S.
Another concern is the impact of climate change and Environmental, Social, and Governance (ESG) events. Here are some of the biggest drivers of new volatility patterns:
You might like: 7 tips for cost-efficient ETF operations
Asset management firms must deeply understand ETF liquidity in order to develop the right trading strategies. This is even more important for complex and large trades.
When making investment decisions, investors will want to know if the liquidity of an ETF aligns with their investment objectives. ETFs that are less liquid not only cost more to trade, but can be more challenging to trade, too.
Let’s explore some of the strategies you can use to better understand trading behaviors.
ADV (Average Daily Volume) is a key metric investors look at to determine the liquidity of a fund. It represents the daily turnover and trade volume of a particular fund and can be compared with the current market environment and the number of shares available to trade each trading day.
Keep in mind that the ETF is a basket of securities, and each individual security has its own liquidity. When an investor wants to determine the liquidity of an ETF, they need to consider the daily trading volumes and spreads of those underlying holdings.
Only authorized participants can interact directly with the ETF issuer, but it’s important for investors to understand the net asset value (NAV) of the underlying securities in the fund in the primary market.
ETFs have multiple layers of liquidity, as covered above. This means investors assessing liquidity will look at both the primary market and the secondary market. Primary market liquidity can be different from secondary market liquidity, creating interesting decisions for investors. Asset managers need to understand where their products fit and how their liquidity measures up to both the primary and secondary markets.
Determining liquidity on the secondary market can be more challenging, but the main indicator will be the bid-ask spread. The bid-ask spread represents the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). Narrower spreads often indicate higher liquidity, as market makers are confident they can easily buy and sell the ETF without much risk.
Market regulations promote transparency and manage risk, which in turn can help increase liquidity.
These are the regulations that affect ETF liquidity, which issuers should keep in mind:
Rule 22e-4. This SEC rule requires ETFs to put Liquidity Risk Management Programs (LRMPs) in place.
Some regulations can boost ETF liquidity. Examples include:
Disclosure requirements. Understanding the disclosures means investors can soberly address risks and deal in reality, reducing panic and rash decision-making.
Of course, regulations can also reduce liquidity. These include:
ETF vs mutual fund: 9 strategic considerations for asset managers
Alternative and crypto ETFs are becoming more mainstream. Here’s why these emerging markets are presenting new ETF liquidity dynamics.
The nature of digital assets such as Bitcoin, Ethereum, and other cryptocurrencies can create unusual liquidity dynamics.
For example:
Digital assets are not the only new kinds of products upending the liquidity applecart. Complex underlying assets (private equity, real estate, and commodities) often have stale pricing that makes real-time NAV calculations unreliable.
Actively managed ETFs present unique challenges, as frequent portfolio changes can disrupt the predictable composition of creation/redemption baskets, complicating arbitrage activities for authorized participants.
Finally, asset managers need to think about capacity constraints in alternative strategies. Capacity constraints can force ETF closures to new investments, eliminating primary market liquidity entirely.
Read about: Best practices for launching an ETF
Investor demand for ETF investing continues to increase. Asset managers need to develop investment strategies for ETF investors that better manage liquidity risk.
Best practices include:
Looking to build a product that minimizes ETF liquidity risk?
VettaFi’s index factory can help you build a reliable product that can navigate today’s increasingly complicated liquidity environment.
The exchange-traded fund (ETF) is increasingly seen as the dominant investment wrapper. In fact, there are now more ETFs available than stocks available for trade.
As ETFs take over more of the market share and investor interest grows, ETF liquidity must be factored into investment strategies to ensure successful outcomes. Here are the factors that impact ETF liquidity, including what every asset manager should know about them in order to help their clients achieve their investment goals.
Liquidity is mainly determined by the liquidity of the underlying assets of a particular fund, as well as the trading activity in secondary markets.
This means an ETF’s liquidity can be affected by the index it tracks. Well-known indexes like the S&P 500, the NASDAQ 100, and the Dow Jones Industrial Average often have more liquid underlying assets, which in turn gives ETFs that track those indexes more liquidity.
The opposite is also true: If an ETF tracks an index that is less liquid, it can reduce liquidity and make trading that ETF more difficult. A complicating factor in this is that ETFs have an open-ended structure that makes the creation and redemption process of ETF shares innately more liquid beyond what investors can determine from looking at the secondary market.
Market makers can increase ETF liquidity by narrowing bid-ask spreads and making ETF trading easier on the secondary market.
However, the current market conditions have created a unique scenario. Asset managers who want to keep their ETFs ahead of the market must update their liquidity assessment approaches.
Some things to keep in mind:
Regional conflicts can affect worldwide ETF trading patterns. When the United States was in a position of global leadership, there was a certain degree of order that could be relied upon even as conflicts broke out. With the U.S. withdrawing from the global stage, there is less of a backstop.
Sanctions and trade restrictions create overnight liquidity constraints. In prior decades, it was easier to determine which nations might be sanctioned. Some countries can get away with substandard policies and suffer minimal international rebuke, while other countries could be slapped with sanctions despite minimal offense. In other words, supply chains and commodity ETF liquidity have become highly unpredictable.
Currency restrictions are also disrupting international ETF arbitrage. As the world begins to move away from the U.S. dollar, that could also further sap the global leverage of the U.S.
Another concern is the impact of climate change and Environmental, Social, and Governance (ESG) events. Here are some of the biggest drivers of new volatility patterns:
You might like: 7 tips for cost-efficient ETF operations
Asset management firms must deeply understand ETF liquidity in order to develop the right trading strategies. This is even more important for complex and large trades.
When making investment decisions, investors will want to know if the liquidity of an ETF aligns with their investment objectives. ETFs that are less liquid not only cost more to trade, but can be more challenging to trade, too.
Let’s explore some of the strategies you can use to better understand trading behaviors.
ADV (Average Daily Volume) is a key metric investors look at to determine the liquidity of a fund. It represents the daily turnover and trade volume of a particular fund and can be compared with the current market environment and the number of shares available to trade each trading day.
Keep in mind that the ETF is a basket of securities, and each individual security has its own liquidity. When an investor wants to determine the liquidity of an ETF, they need to consider the daily trading volumes and spreads of those underlying holdings.
Only authorized participants can interact directly with the ETF issuer, but it’s important for investors to understand the net asset value (NAV) of the underlying securities in the fund in the primary market.
ETFs have multiple layers of liquidity, as covered above. This means investors assessing liquidity will look at both the primary market and the secondary market. Primary market liquidity can be different from secondary market liquidity, creating interesting decisions for investors. Asset managers need to understand where their products fit and how their liquidity measures up to both the primary and secondary markets.
Determining liquidity on the secondary market can be more challenging, but the main indicator will be the bid-ask spread. The bid-ask spread represents the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). Narrower spreads often indicate higher liquidity, as market makers are confident they can easily buy and sell the ETF without much risk.
Market regulations promote transparency and manage risk, which in turn can help increase liquidity.
These are the regulations that affect ETF liquidity, which issuers should keep in mind:
Rule 22e-4. This SEC rule requires ETFs to put Liquidity Risk Management Programs (LRMPs) in place.
Some regulations can boost ETF liquidity. Examples include:
Disclosure requirements. Understanding the disclosures means investors can soberly address risks and deal in reality, reducing panic and rash decision-making.
Of course, regulations can also reduce liquidity. These include:
ETF vs mutual fund: 9 strategic considerations for asset managers
Alternative and crypto ETFs are becoming more mainstream. Here’s why these emerging markets are presenting new ETF liquidity dynamics.
The nature of digital assets such as Bitcoin, Ethereum, and other cryptocurrencies can create unusual liquidity dynamics.
For example:
Digital assets are not the only new kinds of products upending the liquidity applecart. Complex underlying assets (private equity, real estate, and commodities) often have stale pricing that makes real-time NAV calculations unreliable.
Actively managed ETFs present unique challenges, as frequent portfolio changes can disrupt the predictable composition of creation/redemption baskets, complicating arbitrage activities for authorized participants.
Finally, asset managers need to think about capacity constraints in alternative strategies. Capacity constraints can force ETF closures to new investments, eliminating primary market liquidity entirely.
Read about: Best practices for launching an ETF
Investor demand for ETF investing continues to increase. Asset managers need to develop investment strategies for ETF investors that better manage liquidity risk.
Best practices include:
Looking to build a product that minimizes ETF liquidity risk?
VettaFi’s index factory can help you build a reliable product that can navigate today’s increasingly complicated liquidity environment.
