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15th April 2020

The ETF MythBuster: Liquidity

By Hoshang Daroga, CFA, Portfolio Manager of Copia Capital Management

 

Copia ETF MythBusters is a series of blog articles focused on debunking common myths about ETFs.

  • Liquidity is only ever as good as the underlying asset class.
  • Between traditional funds (OEICs) and ETFs, ETFs benefit from the existence of a secondary market
  • In stressed conditions when underlying liquidity is scarce, trading at a quantifiable discount to NAV (for an ETF) is preferable to being gated (for an OEIC) and not being able to trade at all

It is human nature to fear the unknown

Exchange Traded Funds (ETFs) have become an extremely popular investment vehicle among institutional as well as retail investors with over $6 Trillion[1] invested via ETFs globally and growing. The rise in popularity is due to several factors such as, cost-efficiency, transparency, diversification and convenience but the rise in popularity comes with a fair amount of misinformation.

 

Myth: ETFs have a liquidity problem

Like OEICs, ETFs are just another type of a fund structure. The statement “ETFs have a liquidity problem” is very generic and requires more context, much like making a statement “Mutual Funds (OEICs) have a liquidity problem”. The natural follow up question should be “which OEIC or which ETF and by what measure?”

In this article we dive deeper into common myths about ETFs have a liquidity problem and provide evidence that ETFs are no more risky than OEICs, Unit Trusts or other mutual fund structures.

What is liquidity?
In capital markets, liquidity is defined as the extent to which a security (stock, bond, mutual fund, ETF or any other tradable instrument) can be quickly bought or sold without affecting its price at a given point in time. It is a measure of friction while transacting. If the number of shares/units along with number of buyers and sellers is large, then there is less friction and an investor can easily make a trade without compromising on price, making it a liquid security. An illiquid asset is one that cannot be bought or sold quickly and has a large frictional cost associated with making a trade. Buying or selling physical property is a good example.

 

How do you measure liquidity of an investment?
There are many ways to measure liquidity, but average bid/ask spread (%) for a security remains one of the best and easiest ways to do it. Bid/ask spread is the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept to sell it. For example, if the best bid price for a stock is £9.8 and the best ask price for the same stock is £10, then the bid-ask spread for the stock is £0.2 and in percentage terms it is £0.2/£10 = 2%.  For assets where there are ample of buyers and sellers, this spread is very tight. For example, Apple stock which is an extremely heavily traded stock has an average bid/ask spread of 0.007%. This implies that Apple shares can very easily be traded by investors at most times in the market making it a very liquid security.

 

Liquidity in relation to ETFs:

When it comes to ETFs, there are two levels of liquidity. The first, unlike OEICs and UTs, ETFs trade like shares on the stock exchange, which means you can buy/sell an ETF to another investor without the need to approach the fund manager or ETF issuer.

The second level comes through the Authorized Participants (APs), who act as market makers by issuing or redeeming ETF units (shares), to meet the excess demand or supply from investors. The APs are a secondary source of liquidity and helps keep ETF prices aligned with the market value of the underlying assets.

When there is a high demand for an ETF, investors push its price up to a point where its compelling for an AP to make a tiny profit by buying the underlying securities, exchange them for ETF shares and then sell those shares into the market. A similar but a reverse process takes place while redeeming ETFs. This arbitrage activity is crucial in keeping the ETF price aligned with the market value of the underlying assets.

 

Why are some investors concerned about ETF liquidity?
The articles citing concerns on ETF liquidity are only referring to a handful of ETFs that invest in illiquid assets like high yield bonds or emerging market bonds. Liquidity for each ETF is different and depends on the underlying assets.

In order for the APs to provide liquidity, they need to be able to buy/sell underlying securities efficiently. If the underlying assets are liquid (tight bid/ask spreads with a large number of buyers/sellers), the AP can perform the transactions with minimal friction and can ultimately offer investors better bid/ask spreads on the ETF. Conversely, if the underlying assets are illiquid, APs face a difficult time buying/selling the assets ultimately translating in higher bid/ask spreads for the ETF.

This is illustrated in Fig 1. UK Large Cap Equities are easily accessible and very liquid resulting in high liquidity for the UK FTSE-100 Equity ETF (blue line with very small bid/ask spread), while US High Yield Bonds being not so liquid, results in lower liquidity for the US High Yield Bond ETF with wider bid/ask spread.

An ETF, OEIC or any fund is only as liquid as its underlying assets.

 

Source: Copia Capital Management, Bloomberg Data

 

Source: Copia Capital Management, Bloomberg Data

How does liquidity of an ETF compare with the OEIC structure?
We have established that liquidity is a measured by frictional costs while transacting and is dependent on the underlying asset class. To understand how liquidity risk compares, let us assume an investor holds High Yield Bonds through two funds. One is an Index-tracking ETF and the other is an actively managed fund in an OEIC structure.

Liquidity is driven by the choice of the asset class and not the fund structure.

We analyse the impact of an investor attempting to sell both the ETF and the OEIC in the current volatile environment brought about by the Covid-19 pandemic.

1.ETF: In the current market, we have seen larger than normal redemptions on high yield and corporate bonds. With a large number of market participants wanting to sell high yield bonds, the AP/market makers found it difficult to trade high yield bonds resulting in a wider than normal bid/ask spread. This implies that if an investor wanted to sell the High Yield Bond ETF in this volatile, he/she would pay a larger than normal frictional cost reflecting the uncertainty.

If the situation gets exceptionally bad, there will be no participants trading high yield bonds as uncertainty on its price will be very high. In this case the AP will not be able to price the ETF, as the prices of the underlying high yield bonds won’t be available.
If an investor wants to sell the ETF holding in such a situation, the investor could approach the ETF issuer to buyback the ETF shares in exchange for the underlying securities.

Source: Copia Capital Management, Bloomberg Data

2.OEIC: The case is very similar to that of the ETF. Instead of the frictional cost being explicitly seen through bid/ask spreads, the frictional cost in OEICs is implicit.
When an investor issues a redemption request for the OEIC, in normal conditions the fund manager would sell the fund holdings to generate cash and process the redemptions. In the current volatile market environment, the actively managed Bond funds have also found it difficult to process redemptions. Some Active Bond Funds have applied a Dilution Levy. Dilution levy is an additional cost a transacting investor bears as the fund manager incurs higher transaction costs, while trading in chaotic market conditions. This levy also helps safeguard interests of existing investors by not passing on any transaction costs to them.

For some Active Bond Funds the situation has been exceptionally bad where the fund manager had to ‘Gate’ the fund, which means the fund is temporarily closed preventing investors from redeeming any units. We have seen this happen for Direct Property funds as Property is an even more illiquid asset class.

 

Conclusions for retail investors:

• Liquidity risk arises when making a transaction (i.e. buying/selling).
• Losses due to a lack of liquidity are highest during volatile/uncertain market conditions, regardless of fund structure (ETF or an OEIC)
• Liquidity risk is driven by the choice of the asset class and not the fund structure. ETF and OEICs are fund structures and have similar liquidity risks.
• Liquidity of investments is not important if the investment time horizon is long.
• It is important to ensure investments are liquid when investing for shorter time horizons.
• ETFs offer investors transparency by reporting all underlying holdings every day, which gives investors sight of liquidity of underlying holdings.
• Actively managed funds may not be transparent giving investors no insight into the liquidity of the fund. Investors have to rely on the judgement of the fund manager.
How does Copia avoid losses due to lack of liquidity?

As Liquidity risk is very high when markets are volatile, Copia’s investment model does not recommend placing trades during such events. The model lets the chaos settle and will attempt to trigger a rebalance only once liquidity has returned to the markets.

For Model Portfolios that are designed for Copia also chooses asset classes which are liquid

Copia also recommends investments should be made with a long term investment horizon. When investing for the longer term, short term liquidity events have no impact on portfolio returns as prices typically stabilize once the event is over. Liquidity is most relevant to investors looking to buy/sell in the short term.

[1] As of Jan 2020

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