ETF Liquidity Explained
Bradley Kay
Associate Director, European ETF Research
Ben Johnson
ETF Strategist
September 29, 2010
© 2010, Morningstar, Inc. All rights reserved.
<#>
Agenda
× What
is liquidity?
× How
the ETF marketplace works
× Why
the biggest ETFs keep gathering more assets
× Rules
of thumb for ETF execution
× Outlook
2
for the future
What Is Liquidity?
× The
ability to buy and sell a security without moving the price
× Factors
contributing to greater liquidity
× Lots of existing shareholders leads to natural buyers and sellers
× General agreement on the value of the security
× Ready supply of capital for market makers
3
Liquidity in ETFs
× Liquidity
in European ETFs currently comes almost entirely from
market makers who create or redeem shares at the end of day
× Requires a slight spread between buy and sell prices, to
compensate market makers for the costs of hedging
× Market makers are paid to keep spreads at a pre-specified level
(typically below 1% or 2% for some less-liquid funds)
× Since the market maker has to hedge, the liquidity of ETF
portfolio holdings and ease of borrowing capital matter
× The
largest ETFs move toward liquidity coming from existing
shareholders
× Allows for the lowest transaction costs, since buyers and sellers
are happy to receive fair value
4
How an ETF Works
ETF Creation/Redemption Process
ETF Provider
Securities
Primary Market
Secondary
Market
(In-kind transfer)
ETF Shares
Market Maker
ETF Shares
Buyer
Seller
Stock Exchange
5
How a Traditional Fund Works
Graphic Source: Blackrock
6
Liquidity in Traditional Funds versus ETFs
× Traditional
funds still need to tap the capital markets each day in
order to buy and sell portfolio holdings
× Not immune from the transaction costs incurred by market
makers crucial to ETF trading
× Some ability to avoid transaction costs by netting inflows against
outflows
× ETFs
force the purchaser or seller to bear the cost of their trade,
while traditional funds spread it among all existing shareholders
× Makes the cost of liquidity explicit
× Provides the ETF shareholder with a measure of control over their
transaction costs
7
Why This All Matters
× Intra-day
liquidity allows you to see the price where you are buying
and selling, rather than waiting for the end of day
× Allows
you to rebalance a portfolio immediately, rather than waiting
a day or two to get out of one fund and into another
× The
creation and redemption process, and the secondary market on
the stock exchange that allows it, is the key to ETFs’ low costs
× Only interacting with a handful of major market makers keeps
accounting costs minimal
× Pushes trading to arbitrageurs and trading firms who can do it for
the lowest cost, since they make the market at the margin
8
Does It Work?
× The
arbitrage process keeps market prices for the ETF extremely
close to fair value, even as assets change rapidly
× If
the underlying securities in an ETF are liquid, then the ETF will be as
well under the majority of market circumstances
× Unlike stocks, new ETF shares can be created, so prices do not
get driven up substantially by asset inflows
× Example:
a new US ETF from entrant Schwab
× Intended for retail investors, so inflows came from many sources
× Invests in large-cap US stocks, a very liquid underlying market
× Assets grew 100-fold, from $2 million to $237 million, in only six
months
9
Does It Work?
Source: Morningstar Direct
10
Liquidity Over Time
× Liquidity
within all securities markets can vary drastically over time
× Most
visible in ETFs, since their bid/ask spreads make the costs of
trading explicit
× During
market crises, spreads will generally widen as market makers
lose access to hedging capital and investors become less certain
about fair values
× The largest ETFs in the US kept a steady market through the
2008-2009 crisis, sometimes providing far more liquidity than
their underlying securities
11
Dangers of Illiquidity
× Typically
not much of a problem to buy into a less-liquid ETF
× May require more patience if it is not monitored actively by
market makers
× May require going directly to a market maker
× The
loss of liquidity during a crisis tends to be steepest for smaller
and less liquid ETFs within a category, as these are most reliant on
market makers keeping an orderly market
× Not
saved in a traditional fund, as they still need to sell securities in
the vanishing market to meet share redemptions
× Costs spread among all existing shareholders
12
How to Measure Liquidity
× Simple
approximations for liquidity
× More assets =more potential buyers and sellers
× Greater daily volume = more flow, lower margins demanded
× Liquid underlying = easy hedging for market makers
× More
precise measures of liquidity
× Bid/ask spread
× Depth of order book (XLM)
× Premium/discount
× Market impact from past trades
13
Bid / Ask Spreads
×A
large component of buying and selling costs for ETFs is the
difference between the bid and the ask
× Larger
ETFs typically have tighter bid/ask spreads
< $5 Million Assets
> $10 Billion Assets
Bid
25.68
106.39
Ask
26.16
106.4
Spread
1.85%
0.01%
Data as of August 30th, 2010
14
Bid / Ask Spreads
× Liquidity
costs are a crucial consideration when comparing ETFs
tracking similar or identical indices
August
Name
Amundi ETFEUROSTOXX 50 (D)
Lyxor ETFEUROSTOXX 50
EasyETFEUROSTOXX 50 B
HSBCEUROSTOXX 50 ETF
EasyETFEUROSTOXX 50 A
EasyETFEUROSTOXX 50
Ticker Underlying Index
CD5 FP
MSEFP
ETD FP
50EFP
ETEFP
ETB FP
EUROSTOXX 50
EUROSTOXX 50
EUROSTOXX 50
EUROSTOXX 50
EUROSTOXX 50
EUROSTOXX 50
Ytd
Daily
Daily
Net
Daily
Daily
TER
Average Sprea
Average Sprea
Assets
Average
∆M% Average
∆Ytd
(%)
Turnover d (bp)
Turnover d (bp)
Trades
Trades
%
€M
€M
€M
1
5,119
448
32
24
164
0.15 2.77
0.25 299.36
0.25 10.64
0.15 5.14
0.25 1.82
0.25 1.14
0.02
27.75
0.65
1.27
0.00
0.02
4.73
5.77
11.96
15.65
22.85
24.03
-4.27 1.55
-4.05 395.06
-4.24 19.01
-4.26 7.04
-4.22 3.25
-6.44 3.75
Source: NYSEEuronext, Morningstar Direct
15
0.01
41.46
1.27
1.24
0.10
0.12
4.48
5.44
13.61
14.00
36.00
37.00
-8.55
-8.97
-11.85
-9.27
-11.73
Premiums and Discounts
Premium / Discount to NAV history
iShares Russell 2000
iShares S&P500
0.25%
0.20%
0.15%
0.10%
0.05%
0.00%
-0.05%
-0.10%
-0.15%
-0.20%
× Smaller
fluctuations in the past = more liquidity
16
Rules of Thumb for Trading
× Use
limit orders rather than market orders
× Does not rely on a deep order book
× Allows you to set a fair price for the purchase or sale
× Market makers can see your order on the exchange and fill it
× Stop-loss
orders tend to cause the biggest problems
× Drops a market order on the exchange when prices are going
down
× Tends to place a sell order precisely when liquidity is lowest
× Led to major losses in the May 6 “Flash Crash” in the US
× Circuit breakers on European exchanges will keep losses smaller,
but not prevent them entirely
17
ETF Trade Execution Gone Wrong
× ETF
with nearly $1 billion in assets under management
× Relatively
strong liquidity in the secondary market
18
ETF Trade Execution Gone Wrong
× Too
large of a market order for the immediate liquidity on the
exchange
× Market makers do not always want to post their full order size on
funds that they are not constantly monitoring
× This order executed at a variety of prices, with the peak being
19% above fair value
× After the market order went through the books, the bid
immediately came back down to near the fair value of the ETF
× Could
have been avoided by using a limit order
× Look at iNAV to see what fair value of the portfolio is
× Bid, ask, and recent trade prices also give a good idea of the
current fair value
19
Fair Value Pricing
× The
×
×
×
×
iNAV is not always accurate
Foreign stock ETFs trade in Europe even when the underlying markets are
closed
Events can arise when local markets are closed that will impact valuation once
trading opens, but iNAV may not incorporate that change in value
Market makers rely on futures, local listings of foreign shares, demand
changes, and proprietary algorithms to determine a security’s “fair value”
If a large number of trades are occurring at fairly tight spreads, that suggests a
reasonable market price even if it differs from iNAV
Graphic Source: Vanguard
20
Trading Best Practices
× Use
limit orders
× Avoid
stop-loss orders
× Evaluate
the market
× Indicative values
× Recent trade prices
× Bid / ask quotes
× Avoid trading during extreme volatility (Flash Crash)
× Trade
when the underlying market is open and functioning
21
The Future for European ETF Liquidity
× Most
investors are still large, slow-trading institutions
× Even the highest volume ETF in Europe only trades about £50
million per day through the exchange, less than 1/250th of the
volume traded through SPDRs (the world’s largest and most
liquid ETF)
× The market is still reliant on market makers and could face some
trading disruptions in another major crash
× Liquidity
is growing rapidly
× Hedge funds are shifting toward using ETFs in place of OTC
derivatives from investment banks
× Retail investors and advisers are starting to buy off LSE,
Deutsche Börse, and Borsa Italiana
22
ETF Liquidity is Growing Rapidly
Exchange
YTD Trades % Change YOY YTD Turnover (M) % Change YOY
Deutsche Borse
33.3%
€ 107,975
London Stock Exchange 831,707
35.1%
£67,316
47.7%
NYSEEuronext
1,406,420
4.5%
14.0%
€ 64,126
Source: Deutsche Borse, London Stock Exchange, NYSE Euronext
× Year-to-date
× Though
23
trends through August are encouraging
the trend is positive, there is still a long way to go
The Future for European ETF Liquidity
× ETFs
pulling in the greatest amount of assets and putting up the
largest volumes will continue to succeed
× Lower trading costs mean a lower total cost of ownership
× More purchasing across the European exchanges
× A spread that’s only one penny tighter on a £10 share is worth
£100 on a £10,000 trade
× Biggest
ETFs will keep their liquidity even during a crash
× Likely to end up as one of the lowest-cost ways to trade illiquid
asset classes like fixed-income and foreign markets during a
crisis
24
25
