There’s more to ETF liquidity than AUM and ADV, says Deutsche

Nov 16th, 2017 | By | Category: ETF and Index News

A new research note from Deutsche Asset Management argues that the most commonly used measures to assess an ETF’s liquidity may not give investors the full picture.

Look beyond ADV and AUM for ETF liquidity, says Deutsche AM

Investors should consider the size of the order book as well as the liquidity of the underlying securities when assessing an ETF’s liquidity.

The report’s author, Luke Oliver, head of US ETF capital markets at Deutsche AM, argues that while average daily volume (ADV) and assets under management (AUM) might provide investors with an intuitive level of comfort, these metrics may not be sufficient when gauging an ETF’s liquidity.

When trading single stocks, light trading in a small-cap stock clearly makes it less liquid than a mega-cap with a trading volume of $1 billion a day. Buying or selling a significant percentage of a stock’s ADV creates demand and supply dynamics that can, in turn, affect the price of the stock, rightly giving investors cause to be wary.

However, according to Oliver, the same two measures of liquidity, size and ADV, might not be the optimal way to assess ETF liquidity. “This is because an ETF is only a wrapper for a diversified portfolio of stocks or bonds and new ETF shares can be created or redeemed in exchange for slices of this underlying portfolio.” This makes the ETF itself less susceptible to demand and supply dynamics than individual stocks.

Because of this, Oliver states that an ETF’s liquidity can be judged by how much of the underlying portfolio can be bought or sold, rather than the ETF’s present AUM and ADV. Investors should look at the number of shares displayed by market makers at the bid and offer prices in an ETF’s order book.

“These shares can be immediately executed and will likely be restocked at the same or similar price, provided the price of the underlying stocks hasn’t changed,” said Oliver. If the desired amount of ETF shares to be traded exceeds the size quoted in the order book, the extra demand is met by creating brand new shares in exchange for the underlying securities in the liquid global markets and sourcing them through the primary market.

“So, when clients ask how large trades can be executed in small ETFs, I point to the ability to create brand new shares from the underlying securities. When they ask how smaller daily or rebalancing trades can be executed in ETFs that don’t trade frequently, I point to the depth of the secondary market in the order book,“ added Oliver.

The chart below demonstrates the interaction of the primary and secondary markets. Larger trades will be priced from the primary market line, not the ADV-based secondary market impact line.

There's more to ETF liquidity than AUM and ADV, says Deutsche

Source: Deutsche Asset Management.

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