The rapid adoption of Exchange Traded Funds as popular investment vehicles has occurred at a high velocity. Although it may seem straightforward, trading an ETF has more dimensionality than many realise. One key aspect of ETF investing that is commonly misunderstood is liquidity. Higher trading volume ETF’s are more popular amongst the investing public, reflecting this misconception.
How is ETF liquidity different from the liquidity of a stock? Although looking at the trading volume of an ETF may illuminate how many shares have traded in the past, this figure does not reflect the vehicle’s liquidity.
A better representation is the number of shares that can hypothetically be traded; surprising to many, this depends on the liquidity of the underlying constituent holdings in the basket. The reason is quite simple; an ETF is by definition an open ended mutual fund. There is potentially a great deal of flexibility because units are created or destroyed by the issuer based on demand for subscriptions and redemptions. This structure differs from a stock or a closed end fund because it engenders the flexibility to create new shares.
Therefore, a more influential factor in ETF liquidity is the capacity of each of the ETF’s holdings to be included in the basket.
For example, let’s say that we wanted to invest in an ETF that traded over 1 million share volume per day.
At first glance, we would consider it a highly liquid ETF. However, let’s pretend that this ETF included 5 very liquid large cap stocks and one very illiquid small cap. If suddenly a large investor wanted to buy in and the ETF basket called for a large number of shares to be created one day, the small cap may not trade at high enough volume to be included. This could prevent additional units of the ETF from being created in its original basket form. This example serves to illustrate a scenario where the volume traded of the ETF itself is not as issue; rather it is the thinly traded nature of the underlying stock that poses the problem
How would a financial advisor avoid paying large bid-ask spreads and advance their use of the broader range of somewhat lower volume ETF’s? According to David Abner, author of “The ETF Handbook” (Wiley, April 2010) and Director of Institutional Sales and Trading at WisdomTree Asset Management, it is extremely important to understand the different techniques available for execution. Newer ETF users are frequently surprised at the amount of liquidity that can be found in ETFs that may on the surface appear difficult to trade. There are particular asset classes, such as certain types of fixed income, in which how you execute can make all the difference in your position. Using limit orders or accessing upstairs liquidity providers for large trades can lead to a better execution and becomes well worth the extra time spent in the beginning to understand the details of those processes.
The information contained in this presentation contains confidential information regarding Diamond Oak Capital Advisors, LLC (“Diamond Oak”) and may contain information regarding hedge funds and other investments recommended or otherwise analysed by Diamond Oak. This document is not an offer to sell, nor the solicitation of an offer to purchase, any interest in Diamond Oak or any hedge funds or other investments discussed herein. An investment in any hedge fund or other investment discussed herein may be undertaken only through such fund or investment, may be speculative, and may involve a high degree of risk. An investor in hedge funds could lose all or a substantial amount of his or her investment.
Certain information contained in this presentation has been obtained from sources outside of Diamond Oak and its affiliates. While such information is believed to be reliable for purposes used herein, no representations are made as to the accuracy or completeness thereof and neither Diamond Oak nor its affiliates takes responsibility for such information. Past, pro forma, hypothetical, projected, or suggested performance of any investment or portfolio of investments is not necessarily indicative of future performance.
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