An interesting insight into the liquidity of ETFs from Franklin Templeton rightly points out that investors are interested in understanding the liquidity of any asset in which they are invested and seek reassurance on gaining access to their cash in stressed market conditions.

Jason Xavier, head of EMEA ETF capital markets at Franklin Templeton, starts by pointing out that ETFs have two sources of liquidity; the ETF itself and the underlying assets.

To understand this, he explains that the trading and market structure of ETFs share some similarities to stocks but the way that the units are issued is very different.

“The underlying liquidity of a single stock is a function of the finite number of shares outstanding,” he states. “Therefore, the trading volume of the stock gives an indication of the liquidity.

An ETF, by way of contrast, is an open-ended structure that can issue more shares based on demand and can also terminate shares based on redemptions.

“When there are more existing shareholders looking to sell than there are new investors looking to buy, market participants known as authorised participants and/or market makers would step in as buyers,” Xavier says.

“The price at which those market participants would purchase the ETF would be driven by the price at which they could sell the underlying basket of securities, since they would most likely need to redeem shares. This dynamic only gets exacerbated when there is extreme selling pressure.”

He says that investors need to remember that the volume of ETF shares is "not an accurate measure of the underlying liquidity of an ETF". Instead, ETF volumes represent only what has been traded, not what could be traded. To see what could be traded, an investor has to look through to the underlying stocks.

“Hence the liquidity of an ETF, be it a newly issued or established product, is always a function of the liquidity of the underlying assets,” he says.

Watch that arb

Xavier then turns to the issue of arbitrage, pointing out that the purchaser of an ETF expects the price to be in line with the value of the underlying basket of securities. “The concept of arbitrage is what keeps those two values in line,” he says.

Arbitrage, he points out, involves buying and selling essentially the same asset at the same time at two different prices in attempt to take advantage of the price discrepancy between these identical (or nearly identical) products selling in different markets or platforms.

“The difference in prices between the two similar assets is known as the spread,” he says. “The ETF’s arbitrage mechanism facilitated by market makers and authorised participants keeps the price of the ETF in line with its basket of underlying securities.”

Xavier points out that for ETFs with liquid underlying baskets, such as US large-caps, the price of the ETF with high average daily volume should trade at similar levels as an ETF with lower daily volume purely because of the liquidity inherent in the underlying basket of stocks.

However, for a select few liquid ETFs with slightly less liquid underlying baskets – here Xavier cites US small-cap stocks or high-yield bonds - there is a potential benefit for some market participants to transact within the spread of the underlying securities.

“However, when liquidity is needed quickly (particularly when investors look to sell) virtually all ETFs - those with both high and low average daily volumes – trade at price levels more closely in line where market participants could sell the underlying basket.

“That’s because of the arbitrage mechanism explained above — when prices between the ETF and its underlying basket are out of sync, these arbitrage-minded traders (market makers and authorised participants) will step in, causing prices to move back in line.”

Beyond AUM

When it come sot issue around the size of fund, Xavier believes a further misunderstanding creeps in from how investors view mutual funds. Here he posits as an example the potential for someone to put €15m into an ETF with an AUM of €5m, meaning said investor would represent 75% of the fund.

Concerning, perhaps, in the mutual fund arena; not so much in ETFs.

“Let’s think back to how an ETF is created,” he says. “Before the first day of trading, typically there is one firm (the seeding counterparty) that delivers the underlying basket to the ETF issuer in exchange for the first ETF shares.

“This seeding counterparty is often 100% of the fund. If those seeding firms are comfortable owning such a limit, then, in our view, there is no reason any investor should have concerns about the viability of an ETF based on its AUM.”

Instead, Xavier suggests that that is more important is to determine how the ETF fits in terms of asset allocation of an investor’s broader portfolio.

“There are much more important considerations for investors than obsessing about the relative proportion of an ETF’s AUM that they own,” he concludes. “We believe investors should be more concerned with choosing an ETF that gives them the exposures they want, and then making the appropriate investment to deliver the investment goals.”