Advisers don't have a firm grasp of ETF liquidity, Cerulli finds

There's shares and underlying shares and therin lies the confusion.

Jul 18, 2013 @ 3:27 pm

By Jason Kephart

The ability to get in and out of markets quickly has always been one of the most attractive features of exchange-traded funds, but it turns out it may be the feature advisers understand the least.

ETF liquidity was ranked as the subject advisers are least knowledgeable of in a recent survey of ETF companies done by global research firm Cerulli Associates Inc. Almost two-thirds of ETF companies ranked the lack of understanding around how liquidity works as a major challenge to the continued growth of ETFs.

“There is a misconception that you can just look at the trading volume of an ETF,” said Alec Papazian, associate director at Cerulli.

Trading volume is actually only part of the ETF liquidity puzzle, though.

“The confusion comes from the fact that ETFs have two layers of liquidity,” said Sue Thompson, head of the RIA group at BlackRock Inc., the parent company of iShares, the world's largest ETF firm. “With stocks or mutual funds there's only one layer of liquidity.”

On one hand, there's the ETF's primary liquidity, which is based on its underlying assets. An ETF that invests in U.S. large-cap stocks is going to tend to be very liquid, no matter its trading volume, because of the high liquidity of U.S. large-cap stocks. ETFs that invest in less liquid securities like municipal bonds or emerging markets small-cap stocks, are going to be less liquid because the underlying securities are less liquid.

However — and this is where it gets a little tricky — the shares of ETFs that invest in less liquid securities can trade much more often than their underlying securities.

“The beauty of the ETF is it took something that was illiquid and made it far more liquid,” Ms. Thompson said.

The ability to trade ETF shares more often than the underlying securities can lead to the share price deviating from the net asset value. That can lead to a premium if there's a lot of buying or a discount if there's a lot of selling. Premiums and discounts tend to only pop up during extreme times of buying and selling and generally even out over time.

Getting advisers comfortable with how ETF liquidity works is a high priority for ETF companies because there's still a lot of room for the products to grow.

BlackRock estimates just 6% of adviser portfolios are allocated to ETFs. Overall, 29% of assets are in passively managed funds, according to Cerulli.

Wirehouses and registered investment advisers are the two heaviest users of ETFs, with 63% and 55% of advisers in those channels using ETFs, respectively, according to Cerulli. Independent broker-dealers and regional advisers are the least likely to use ETFs, with just 39% and 42%, respectively, currently using ETFs.

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