ETF liquidity still “widely misunderstood”, says FocusShares CEO

May 14th, 2012 | By | Category: ETF and Index News

The liquidity and marketability of ETFs are still “widely misunderstood” by professional and individual investors, said Erik Liik, president and CEO of FocusShares, a US ETF provider, in a statement today.

ETF liquidity still "widely misunderstood", says FocusShares CEO

Erik Liik, president and CEO of FocusShares.

A survey conducted for a new Cerulli Associates research report, ‘Quantitative Update: ETFs and Retail Alternative Products and Services’, highlighted this issue when it found that nearly 70% of ETF sponsors said misunderstandings about liquidity and trading volume hindered potential sales.

Liik defined liquidity as the ability to buy or sell an ETF close to its net asset value (NAV), which is the value of underlying securities minus fees. “Most ETFs – especially domestic (US) equity funds – are highly liquid,” Liik said, “because each ETF share is invested in liquid securities.”

It’s relatively easy for investors to know whether they are buying or selling an ETF at or close to net asset value because every 15 seconds the estimated NAV of each ETF is made available to the public.

The Cerulli report notes that investors are “falsely weary” that the association between volume and liquidity “will hinder their ability to move large positions in and out of funds with low volume.”

ETF shares can be created and redeemed instantly, depending on market demand, Liik said. “Filling large orders is easily done with ETFs,” he said.

Here Liik is referring to a key liquidity feature of ETFs, namely the option to deal directly with an Authorised Participant – essentially a broker who is also able to create and redeem ETF units – in what is known as a primary trade.

This multi-dealer creation/redemption mechanism enhances the liquidity of ETFs and ensures that any discount to its NAV remains minimal – in theory the creation/redemption process arbitrages away any NAV discrepancies. The primary market also enables institutional investors to execute large trades at efficient cost, while avoiding adverse market impact.

In terms of ETF liquidity, therefore, investors should look at the liquidity of an ETF’s underlying constituents, rather than simply the average daily volume of the ETF itself. This is because, instead of trading the ETF, larger investors are able to buy the underlying basket of constituents (using, for example, a volume-weighted average price approach across the trading day) and then have an Authorised Participant create a new ETF share.

This process lowers trading costs because the actual underlying constituents are typically more liquid than the ETF itself.

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