It’s that time of year when Halloween decorations start to appear in shop windows and many of us start thinking about weekend activities with the children that may include trips to the pumpkin patch or apple orchard. In fact, this past weekend, I stopped by a lovely orchard with a small farm stand selling apples and other local produce. Perhaps I spend too much time thinking about work, but the scene immediately conjured up a visual solution to a question asked almost daily of me regarding ETF liquidity. The answer? No one asks the farmer how many apples he sold yesterday when they’re buying an apple today!
Let me explain. Historically, investors have estimated the liquidity of a stock (i.e. the ease and efficiency with which a security can be bought or sold), by considering how much of the stock exists (market capitalization of the company) and, to a larger degree, how much of the stock is bought and sold each day (average daily volume). This makes perfect sense for a single security. Thin trading in a small cap company naturally makes it less liquid than a huge company that trades a $1bn per day. Purchasing or selling a meaningful percentage of a stock’s average daily volume (ADV) creates demand and supply dynamics that can in turn affect the price of the stock rightly giving investors cause to be wary.
This same logic is frequently applied to ETFs. No doubt high assets under management (AUM), analogous with market cap in this case, and a high ADV, provide an intuitive comfort level for investors. However, these metrics are far from mandatory when gauging the tradability of an ETF. This is because an ETF is only a wrapper for a diversified portfolio of stocks or bonds and new ETF shares can be created or redeemed in exchange for slices of this underlying portfolio. This makes the ETF itself less susceptible to demand and supply dynamics. Therefore, the ETF’s liquidity can be judged by how much of the underlying portfolio can be bought or sold, rather than the ETF’s present AUM and ADV.
Getting back to the farmer, imagine that we want to purchase a bag of apples from the farm stand. With the exception of the McDonald’s “Over one million sold” slogan, most businesses don’t have a sign out front telling you how many apples were sold yesterday (ADV in this story). Nor do they publish an accumulative sum of all apples they’ve ever sold (the AUM). That’s because it’s irrelevant to your ability to buy apples today. So, what metrics may be appropriate when measuring the ability to buy apples?
Most of us would glance at the farm stand shelves and note that an inventory of 50 bags of apples would suggest that buying one, ten or 50 bags should not present a liquidity issue. The same concept can be applied to ETFs by looking at the number of shares (for sale at the “offer” price and for purchase at the “bid” price) displayed by market makers in the ETF’s order book. These shares can be immediately executed and will likely be restocked at the same or similar price, provided the price of apples (I mean stocks) hasn’t changed. These shares are part of what we call the “secondary” market.
Imagine for a moment that we decide to really test this theory and request 300 bags of apples. The farmer never sold 300 bags in a week, let alone a day. In fact, the total number of bags ever sold was only 100. But the farmer doesn’t flinch. Remember, she has access to an orchard full of apples in addition to barrels of loose apples. The farmer simply needs to bag the apples (much like delivering the stocks into the ETF wrapper). With ETFs, the extra demand is met by creating brand new ETF shares in exchange for the abundant underlying securities in the liquid global markets and sourcing them through the “primary” market.
So, when clients ask how large trades can be executed in small ETFs, I point to the ability to create brand new shares from the underlying securities. When they ask how smaller daily or rebalancing trades can be executed in ETFs that don’t trade frequently, I point to the depth of the secondary market in the order book. The chart below illustrates the interaction of primary and secondary markets. Larger trades will be priced from the Primary market line, not the ADV-based Secondary impact line.
Of course, liquidity levels in the underlying markets can vary, depending on factors such as segment, region and asset class.
The good news is with ETFs, the process works equally well with purchases as well as the sale of ETF shares. A word of caution, don’t try this with the farmer, she wasn’t particularly happy when I told her the order for 300 bags was just for illustrative purposes.
Don’t let an AUM and ADV get in the way of great ETF strategy.