ETF Liquidity: A vital measure of efficiency

What does the liquidity of an ETF mean?

In simple terms, the liquidity of an ETF is the ability of the fund to meet investors’ buying and selling orders without a significant impact on its price. This liquidity reflects a number of factors, primarily the liquidity of the underlying market, but it also reflects structural features of the ETF.

The secondary market price of an ETF is set freely by market participants based on price moves in the underlying securities. The highest buying order for a fund (best bid) and the lowest selling order (best offer) set the ETF’s bidoffer spread. The depth of an ETF’s order book shows the capacity of the market to absorb larger transactions.

In Europe, a significant part of ETF trading takes place away from exchanges in the bilateral, over-the-counter (OTC) market. OTC market orders also contribute to the liquidity of an ETF.

What’s the difference between the liquidity of an ETF, an ordinary share and a traditional fund?

An ETF is a hybrid between an ordinary share and a traditional fund. Both ETFs and ordinary shares are traded on stock exchanges throughout the day; by contrast, a traditional mutual fund usually has a single daily entry/exit point for investors wishing to buy or sell. But an ETF’s share capital, like that of a traditional fund, is variable (open-ended), whereas the share capital of a company does not vary in response to market supply and demand. This feature means that supply and demand is less relevant for ETF pricing than moves in the price of the underlying securities.

Why does an ETF ’s liquidity matter for investors?

ETFs’ ability to offer investors low-cost and flexible exposure to a variety of asset classes is the key reason for their popularity. Part of ETFs’ low-cost promise is that their average fund expenses are usually lower than those of comparable actively managed funds. But the cost to enter and exit an ETF is also frequently lower than that of a traditional fund. The ability to transact in ETF shares at the time of their choosing and at relatively low cost is very attractive for investors.

From where is an ETF ’s liquidity sourced?

The liquidity of an ETF is sourced from both the primary and secondary markets. In the primary market, specialised intermediaries called “authorised participants” or “APs” transact directly with the ETF issuer to «create» and «redeem» ETF shares: new ETF shares are issued if demand is high or existing shares are withdrawn if there is too much supply.

The secondary market is where continuous trading in ETF shares occurs. Secondary market transactions can be in any number of ETF shares.

The primary and secondary markets of an ETF are linked. A liquid secondary market in an ETF’s shares depends to a great extent on an efficient primary market mechanism. Lyxor is constantly working on its primary market setup to make sure it is as supportive of liquidity as possible.

What can an ETF issuer do to influence the liquidity of its funds?

Although an ETF issuer has no direct impact on the secondary market liquidity of its funds, it can influence a fund’s liquidity positively by putting in place a robust, diversified and flexible primary market structure.
Lyxor does this in three ways. First, we operate an open access model, contracting with over 50 APs to create and redeem units in Lyxor ETFs. Second, we offer APs an efficient creation/redemption process, with creation and redemption fees that reflect the actual cost of trading the underlying securities, a low minimum creation size and flexibility in terms of the assets that the AP may offer in exchange for the ETF units (for example cash, futures or an index basket). Third, over 15 official liquidity providers quote continuous bid and offer prices on exchanges throughout Europe, bringing liquidity to the order book of Lyxor ETFs.
Together, these measures have made Lyxor’s ETFs among the most highly traded in Europe.

What is an ETF ’s “fair value band”?

The secondary market price of an ETF typically fluctuates freely within a so-called “fair value band” around the fund’s indicative net asset value (iNAV). The iNAV measures the fair value of an ETF share during continuous trading.

The fair value band reflects the cost to the AP of creating and redeeming fund units. For example, when accumulating the shares to place a creation in an equity ETF, the AP will pay what we call arbitrage costs: part of the bid-offer spread on the underlying shares, plus any applicable commissions and taxes. The upper limit of the fair value band exceeds the ETF’s iNAV by a margin that reflects these creation costs. Similarly, the lower limit of the fair value band reflects redemption costs.

What happens if transaction taxes are payable on the underlying securities?

If transaction taxes are payable on purchases of the securities that make up the ETF’s creation basket, the upper limit of the ETF’s fair value band will reflect the cost of paying those taxes.

For example, an ETF owning UK shares will have a fair value band that reflects the 50 basis point (0.5%) stamp duty reserve tax (SDRT) payable on purchases of UK shares. Lyxor’s ETFs tracking UK share indices typically own other European shares, together with a performance swap, under which a counterparty promises to pay the return on the index. This means that creation costs in a Lyxor ETF tracking a UK share index are relatively lower than in a fund that owns UK shares directly.

In the chart we show the price deviations from NAV over time of two ETFs tracking the FTSE 100 index. One ETF’s price trades at a frequent premium to NAV, reflecting the 0.5% SDRT. The price of the Lyxor ETF stays much closer to NAV.

Why is the secondary market bid-offer spread of an ETF often lower than the average spread on the underlying securities?

The liquidity of an ETF consists of two layers: the first one is the liquidity of the underlying securities, and the second is the intrinsic liquidity of the ETF itself. As we explained earlier, the secondary market bid-offer spread of an ETF is set by the interactions of the many investors, traders and arbitrageurs placing buying and selling orders. As a result of this interaction of buying and selling demand, an ETF’s secondary market bid-offer spread is often narrower than the average spread payable on the full basket of index securities.

For example, whereas a typical bid-offer spread in a corporate bond may be a percent of the bond’s notional value, the spread of a corporate bond ETF may be a few basis points (hundredths of a percent).

Narrow ETF secondary market spreads reflect the inherent efficiency of a pooled investment vehicle with a diverse base of investors and traders. However, it’s important to remember that, by contrast with a traditional fund, which usually has a fixed spread between buying and selling prices, an ETF’s spread is variable. And in stressed market conditions spreads may widen to reflect the full cost of trading the underlying index basket.

Why is the full liquidity of an ETF sometimes “invisible”?

Not all of the latent demand to buy or sell ETF shares is displayed on stock exchanges’ order books. Partly, this reflects the fragmentation of exchanges and other trading venues in Europe – meaning that liquidity is split between the multiple listings of the same ETF. But the widespread practice of trading ETFs in the OTC market also leads to a general underreporting of trading volumes.

The liquidity of an ETF is based on the liquidity of the fund’s underlying securities. Not all that underlying liquidity may be shown in the ETF’s own reported trading volumes. As a result of this hidden liquidity, it may be possible to place an order that seems large by comparison with reported volumes, without having a significant impact on the ETF’s price. Investors should remember that this hidden liquidity exists.

How can liquidity be measured?

The best objective measure of an ETF’s liquidity is the data published by Europe’s stock exchanges.

However, given the fact that part of an ETF’s liquidity may be hidden, transaction cost analyses can also be based on the ETFs’ underlying securities. Many market intermediaries provide such analyses and Lyxor’s capital markets team can also help investors assess an ETF’s fundamental liquidity.

Do competing ETF s on the same index have the same bid-offer spreads?

Not necessarily. ETFs from competing issuers that track the same index can have different bid-offer spreads for a variety of reasons: more or less efficient primary market structures; differences in the number of market makers active in a particular fund; and differences in fund size. Other things being equal, a larger fund tends to attract more trading volume, leading to lower spreads, in a virtuous circle effect.

The chart below, which shows 5-day moving average bidoffer spreads on three European ETFs tracking the MSCI World index, illustrates that such differences exist.

How will regulatory changes affect European ETF market liquidity?

We expect ongoing regulatory changes to have a positive effect on the ETF market’s liquidity.

Currently, for example, the reporting of OTC transactions in ETFs is voluntary in many European markets. However, under the second version of the Markets in Financial Instruments Directive (MiFID II), which was passed in April 2014, a “consolidated tape” of trades in shares, depositary receipts, ETFs, certificates and other similar financial instruments is due to be introduced by the end of 2016. The consolidated tape will be available free of charge 15 minutes after its publication. All ETF trades, including the ones conducted OTC, will therefore be visible. This added transparency will show the true liquidity of ETFs.

Another regulation, the Central Securities Depositary Regulation (CSDR), is due to harmonise settlement and buy-in rules across Europe’s exchanges and settlement systems. This should also help to reduce the current market fragmentation in Europe.

How does ETF liquidity impact Lyxor’s efficiency measure?

Liquidity is a key part of Lyxor’s framework for evaluating the efficiency of an ETF. An ETF’s secondary market liquidity, measured as its exchange-based bid-offer spread, is one of the three factors contributing to any ETF’s efficiency score. The wider the spread of an ETF, the lower its efficiency score.

The other two factors contributing to the efficiency score are an ETF’s performance and its tracking error.

From where can an investor obtain advice about the best ways of executing ETF trades?

Many market makers and broking firms now have specialist ETF advisory units, who can offer advice on the best way to execute ETF trades: for example, how best to time trades to source times of peak liquidity in the underlying market, whether to place a market or limit order or to trade by means of an algorithm. It’s worth developing relationships with a few trusted counterparties from this group of intermediaries.

Although Lyxor’s ETF capital markets team does not buy and sell ETFs, we are there to offer objective guidance to investors wishing to source ETF liquidity. We can often help unearth market inventories or demand, enabling clients to reduce execution costs. We encourage anyone to pick up the phone and get in touch!