Picking the right ETF: Liquidity

Lack of liquidity is treacherous for everyone.

Catastrophe in capital markets is always characterized by a lack of liquidity. Significant imbalances between buyers and sellers (widened bid-ask spreads) can create market “gaps”. Occasionally this happens to the upside but predominately it occurs on the downside. Examples: October 1987, September 2001, Q4 2008. Liquidity is important for investors, but a lack of liquidity is treacherous for everyone.


Liquidity of underlying securities

Since the 1990 launch of the first exchange-traded fund (ETF), the Toronto Index Participation Securities (TIPS), liquidity has been important. Originally developed for retail investors, TIPS became popular among institutional investors seeking broad market access in part because of the liquidity of the 35 stocks underlying TIPS. It follows that ETFs with illiquid holdings should be watched carefully. Fixed income ETFs can fall into this category.

Theoretically, trading volume and liquidity for today’s ETFs is not a problem with the creation/redemption mechanism. This structure authorizes designated brokers to create additional units if demand exceeds supply, and conversely, remove units when supply exceeds demand. But there are differences in bid-ask spreads impacting every investor’s bottom line that require explanation.


Timing and volume

“An ETF manager may be doing a terrific job of tracking an index,” says Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, “but the retail investor may still be impacted by liquidity costs, paying a hefty price in the form of wide bid-ask spreads or volatile premiums/discounts to net asset value (NAV), all resulting in less than stellar market liquidity.

“Transacting before a holiday or at other times when volume is expected to be low, can be expensive and should be avoided. For example the closing bid-ask spread for actively traded iShares CDN S&P/TSX 60 (XIU), as of Friday, October 9, 2009 (Thanksgiving weekend) was $17.08-17.10 or 11.7 bps (normally about 5.8 bps) and for less actively traded Claymore Canadian Fundamental Index ETF (CRQ), was $10.85-10.99 or 129 bps (normally about 28 bps). Bid-ask spreads are generally correlated with trading volume and tend to be tighter for ETFs with more assets under management as the examples above demonstrate. 3 month average trading volume: XIU 17.6 million shares vs. CRQ 35,632 shares. The chart below demonstrates that trading volume and bid-ask spreads are correlated. This is not a surprise. More activity reflects popularity which suggests better arbitrage opportunities to keep spreads narrow and ETF values close to NAV.

“Poor liquidity can cost investors money. Most ETF prices oscillate around their NAV. The absolute level of premium/discount and its standard deviation, a measure of how far, on average, the market price of an ETF tends to deviate from the NAV, warrants scrutiny. Some ETFs, primarily fixed income, trade mostly at a premium. For these ETFs, the magnitude of the average premium depends on the liquidity of the underlying assets, a good example being iShares Canadian Real Return Bond ETF, (XRB). Due to the limited depth of the Canadian real return bond market, this ETF tends to trade at a premium to NAV, closing at $20 on October 9, 2009 with a NAV of only $19.75, or a 1.27% premium.”

The daily historical premium/discount to NAV for the XRB is shown below.


Conclusion

The overall measure of ETF liquidity is a combination of factors; bid-ask spreads, fund assets, trading volume, premium-discount and last, but not least, the liquidity of the underlying assets. Imbalances can lead to tracking error that can distort strategies (to be covered in a future article).

If investors intend to hold positions for longer than 6 months, liquidity may be less of an issue, but larger spreads can be costly over time to frequent traders. A rule of thumb for liquidity is that if the securities underlying the ETF are popular, the ETF’s construction is transparent, and trading is active, liquidity should be pretty good.

PŮR Investing Inc. offers a free ETF screener on their website that includes liquidity: www.purinvesting.com.