Liquidity is an important characteristic to consider when aligning security selection with investment objective. The need for capital protection and ability to convert an investment holding to cash is essential for shorter or unpredictable time horizons, but it is less important when investing for a retirement goal 30 years out. Investors may often evaluate a stock’s liquidity by its trading volume. While this may be a starting point when looking at a common stock, it’s less effective when evaluating exchange-traded funds (ETFs), as it fails to take into account the structure behind the ETF that ensures its liquidity. The result is often a misunderstanding of an ETF’s liquidity and one of the most persistent myths in our industry.
For any security trading on the stock market, the price is simply the auction price agreed upon by the buyer and the seller. An investor looking to make a sizeable investment in a single thinly traded security would be justified in their concern of potentially moving the market, driving the price higher and resulting in a poor outcome. However, daily trading volume only provides a small indication of an ETF’s liquidity. Unlike a single stock, the supply of an ETF is open-ended; new ETF shares can be created and existing shares can be redeemed on demand. This structure not only maintains the pricing integrity and ensures trading takes place around the net asset value (NAV), it also provides a structure for liquidity. Thus, the liquidity of an ETF is much more than its daily trading volume.
The liquidity of an ETF is more accurately determined by evaluating the liquidity of its underlying holdings. Whereas daily ETF trading volumes reflect the trading activity of the security on the secondary market, the liquidity of the underlying securities may indicate how effective the ETF sponsor and market makers will be in the primary market when absorbing flows into an ETF. This can sometimes be referred to as implied liquidity.
Implied liquidity is an indication of the liquidity of an ETF as a function of its holdings, rather than trading volume. When an ETF is bought or sold, the buyer and seller are essentially trading a basket of the securities that make up a unit of that ETF product. As the basket must contain every security within the ETF, it can only be as liquid as its least liquid security. In other words, implied liquidity is an estimate of how much assets an ETF could absorb based on the liquidity of its underlying holdings, without having a bigger price impact on those securities.
Based on the value of the underlying portfolio (NAV)
Based on supply/demand of the stock
Supply of shares
Primary source of liquidity
Trading activity of the underlying securities
Trading activity of the stock
Best measure of liquidity
Implied liquidity or daily trading volume of the underlying securities
Daily traded volume of the stock
The rise in popularity of ETFs is partly due to the added liquidity and transparency they offer over traditional mutual funds. Investors still gain the benefits of diversification while benefitting from the ability for intraday trading on the open market. The Canadian ETF industry now has over $250 billion in assets under management with over 1000 ETF products.1 This proliferation of ETF sponsors and products will undoubtedly result in some ETFs having a lower daily trading volume. To help investors avoid missing out on opportunities that may best serve their investment goals, it is more important than ever to fully understand the liquidity function of the ETF creation and redemption process.
Greater awareness around the processes that provide liquidity, and how to best trade ETFs and effectively navigate spreads will only increase adoption and help to continue to demystify the investment solution. As investors’ needs continue to become increasingly complex, education to simplify the products available and enhance the understanding of Canadian investors is to everyone’s advantage.
1CI Global Asset Management as at December 31, 2020.