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How to ease clients' minds about ETF liquidity concerns

Trade-offs between ETFs that fit your clients' needs, and ones that can compromise their needs could be the difference between success or failure

Apr 20, 2016 @ 12:42 pm

By Brandon Clark

We've come a long way from the early days of ETFs, when only a handful were on the market. Today, there are many options available to investors, and more compelling solutions to clients' needs.

Yet even with all the advancements the industry has made, when it comes to understanding ETF liquidity and trading, we've had the same conversations for more than 10 years: “I like your product, but it isn't liquid enough to use,” investors say. “How do I know I can get out of it? “If it only had more volume.” “It's hard to trust something that isn't trading.”

These are real concerns — and good old-fashioned bunk.

It's entirely normal for clients to be concerned about liquidity in any of their investments, but all financial instruments do not work the same way. Sometimes they focus on the wrong things.

Investment exposure should be the main priority. Making trade-offs between “low-volume” ETFs that fit your clients' needs, and “high volume” products that can compromise clients' needs could be the difference between their success or failure.

(Related read: Debunking big ETF liquidity myths)

ETF LIQUIDITY

Having had a hand in launching more than 50 ETFs over the last 10 years, I can report that it is very rare for any ETF to launch with meaningful volume in the beginning months. ETFs that now trade millions of shares a day traded much less when they launched.

Even now, more than 90% of ETFs trade fewer than 500,000 shares per day, and 75% trade less than 100,000 shares per day, yet many of these products have significant assets. The reality is most clients use ETFs as asset allocation tools, not trading vehicles.

“An ETF is as liquid as its underlying holdings” has become a mantra. I, too, have been guilty of saying that, almost as a reflex, but what does it really mean? We must be careful to put these issues into context for our clients.

Trading an individual stock is easy to understand; that's what retail investors usually think of when they think of “liquidity.” But just as ETFs effectively represent a large basket of individual stocks, the ETF itself trades more like a big basket than one stock. Trying to trade 20% of an individual stock typically will result in pushing a stock price. An ETF, as a basket of stocks, means smaller trades in those individual stocks.

To comprehend this requires understanding how liquidity in ETFs is formed. An ETF is simply a wrapper around a basket of stocks. That's it. The concept is not complicated. The stocks in that particular ETF basket continue to actively trade in the market. Nothing changes with regard to the individual stocks by bundling them together into an ETF: Apple is still Apple.

(More ETF insights: Increased SEC scrutiny making ETF providers uncomfortable)

While an ETF may report low daily volumes, trading activity in its underlying stocks — think large-caps like Google, IBM and Exxon — can be leveraged by market-makers in order to facilitate trading orders. This can create instant liquidity for the ETF. It's not that different than buying other investment products, where a portfolio manager (“PM”) has to go to the market with the cash coming in from investors and buy the mandated securities. In the case of ETFs, a market maker, or “authorized participant” plays the role of the PM.

In many cases, the bid/ask spread of an ETF generally will be less than the cost to acquire the basket of stocks it represents. A small cap ETF may have a spread of 10 basis points (“bps”) or less, where the basket of securities bid/ask spread may be 20-30bps. Clients can potentially get a very good deal using ETFs.

HOW DOES IT WORK?

Most stocks in an ETFs trade hundreds of millions, or billions of dollars a day. Thus a $10 million trade in many U.S. or international equity ETFs represents a small fraction of the underlying stocks trading activity. Regardless of the ETF's average daily volume, in normal market conditions many client ETF trades can usually be quickly facilitated, small or large.

This sounds counterintuitive. If an ETF trades only a few thousand shares on most days, why would a $10 million trade be easy to execute?

Because the liquidity necessary to make the trade is built into the underlying stocks. They trade actively, sometimes furiously, and on most days market makers can easily buy and sell the necessary stocks when ETF orders are placed. Investors rely on the large-scale liquidity of the broad market of the stocks held in their ETF basket to provide the leverage they need to trade.

It's not until clients start to trade very large blocks or more illiquid assets classes that they have to consider putting a trading plan together. Regardless of how large or small your ETF trade size, working with a knowledgeable ETF trading desk can help maximize an ETF's liquidity. This happens every day in a landscape where many ETFs can trade 10 or 20 times their average daily volume — or more.

That's not alchemy, it's liquidity in action.

(Even more on ETFs: InvestmentNews' Spotlight on ETFs special report)

ETF TRADING BEST PRACTICES

In seeking fair execution and access to the full-potential liquidity when buying and selling ETFs, take the below best practices into consideration:

• Use limit orders. Most of the bad client experiences I have seen resulted from market orders and stop orders. Opting for limit orders, which is an order placed with a brokerage to buy or sell a set number of shares at a specified price, avoids many pricing problems.

•Utilize a broker's block desk. These experienced traders can better maximize an ETF's underlying liquidity quickly and efficiently by working their network of market makers.

•Avoid trading at market open. Prices tend to swing in the early hours. Not giving the market time to settle in can have a meaningful (negative) impact on execution quality.

So the next time you are looking for an ETF solution to solve a client's needs, do not eliminate what may be the best solution simply because of how little it trades. Talk to the ETF sponsor about liquidity. Most can quickly assess how it matches both your client's investment goals and liquidity needs. A little time and discussion could make the difference in the success of your client's investment plan.

Brandon Clark is a director of ETF product management at Legg Mason.

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