I remember going to a college basketball game several years ago and being in awe of the pep band drummer. He was a master, to say the least, with his skill matched only by his equally hardcore appearance. Upon leaving the game, however, he passed me in his car with the windows rolled down listening to Johannes Brahms’ Hungarian Dance No. 5. Sometimes you just can’t judge a book by its cover.
The same is true with exchange-traded funds (ETFs) when understanding their liquidity. Unlike individual stocks or bonds, whose liquidity can be represented by daily trading volume, ETFs have two measures of liquidity:
- Primary, or implied liquidity – how liquid the ETF’s underlying securities are; and
- Secondary liquidity, or tradability – the ease at which one can buy or sell the actual ETF shares.
These may seem like minor discrepancies, but knowing the true liquidity of your ETFs could help save you from raising trading costs and overlooking a “seemingly” risky or illiquid investment. Also, as Warren Buffet once said, it’s never good to “…invest in a business you cannot understand.”
Before going on though, I believe a crash course in the ETF creation and redemption process would be to our benefit.
ETF Creation and Redemption
ETFs essentially represent ownership in a “bundle of securities.” For example, SPDR’s S&P 500 ETF (ticker symbol “SPY”) is a near-perfect replica of the S&P 500 Index by its holdings and their respective weights. ETFs can also be created or redeemed based on supply and demand.
When an investor wants to buy an ETF share (let’s just stick with SPY for convenience), they contact a broker or exchange, who then places an order with an Authorized Participant (AP) on the primary market – the market between AP’s and special institutional investors. An AP can be a large broker-dealer or investment bank who has the capital to buy and sell large quantities of securities. The AP then buys the actual basket of securities that the ETF represents (in the case of SPY, all the stocks and their respective weights that are in the S&P 500 Index). Finally, the AP contacts the ETF provider and exchanges the securities basket for a “creation unit,” which typically represents 50,000 ETF shares. These ETF shares can then be bought and sold on the secondary market – between retail investors – just like stocks. Each ETF represents fractional ownership in a diversified basket of assets. Think of ETF shares as being slices of a whole securities pizza. Luckily, this one forgoes the anchovies.
ETF redemption works in reverse. As investors sell their shares, the AP buys them until a full “creation unit” (50,000 ETF shares) is made and then redeems it with the fund provider for the underlying securities basket containing the physical securities.
NAV: An ETF’s “Fair” Price
One final, but fundamental note before tackling the “liquidity problem.” An ETF technically has two prices: its share price and its “fair” net asset value (NAV). The share price is the price at which an ETF can be bought or sold on the market at any given time. NAV, however, is the net value per share of the ETF’s underlying securities and is calculated as such:
When trading individual stocks or bonds, the price already reflects what the market thinks is a fair value for that security. But since ETFs can represent hundreds of securities, the NAV gives investors an idea as to what the value ought to be.
Share price and NAV may differ slightly, but are usually very close thanks to the creation and redemption process. As demand for the ETF goes up, so does the ETF share price – but demand hasn’t increased for the underlying securities themselves. Therefore, the ETF share price may be trading at a premium to what the underlying is trading at…and no one like to spend more money than what the underlying is worth. To accommodate this increase in ETF demand, AP’s buy up the cheaper underlying securities, which increases demand (and raises the underlying prices), and then sells newly formed ETF shares for a profit (which lowers the ETF price) to bring the ETF share price and NAV back into equilibrium. This process also works in reverse and helps keep ETF prices in line with the performance of the actual underlying securities. It’s a win-win.
The “Underlying” Problem with Liquidity
Coming full circle, we know that ETFs represent certain securities, but can also trade independently, and at differing values from, those same securities. This creates a problem. What if an ETFs trading volume is high (secondary liquidity), but its underlying securities are hardly ever traded (primary liquidity)? Or vice-versa?
For ETFs with a low primary liquidity, it may be difficult and downright expensive for APs to purchase all the underlying securities needed to form a “creation unit.” Securities that don’t trade regularly have a larger bid-ask spread, thus they become more expensive to buy and sell (this typically happens to high-yield corporate bonds). So as demand for the liquid ETF fluctuates, APs may let the share price drift from the “fair” NAV until the gap is so wide they’re certain they can make money. Remember, whether AP’s are creating or redeeming ETFs, they are still in the business of buying low and selling high.
To give you a better idea of this, below are two charts showing the price-NAV percent premium or discount for SPY (the very liquid S&P 500 ETF with equally liquid underlying stocks) and the humorously labeled JNK (a liquid ETF underlined by illiquid high yield corporate bonds). As you can see, over the last year SPY stayed within a consistent five-basis point boundary – give or take a few spikes. JNK on the other hand is prone to much larger premia and discounts, typically 50 basis points or so.
Be aware though that a price-NAV deviation is not always bad. For example, International ETFs may be trading in the U.S. while the exchanges of the underlying securities are closed. This can cause ETF premia and discounts, but they are due to price discovery, not necessarily a liquidity problem. Once those markets open again, share price and NAV should equilibrate. It is important to understand the reasoning behind premia and discounts.
On the other hand, ETFs with low secondary liquidity may have very liquid underlying securities. Typically, if an investor wants to trade a large amount of an illiquid stock, the first few shares will go for the market price, but the price of each additional share rises with demand. This can make a large trade marginally more expensive. With ETFs, however, this problem can be circumvented thanks – again – to the creation and redemption process which allows new shares to be created to match demand. The below JPMorgan chart shows that large trades can be made without impacting an ETF’s share price.
We’ve Got Your Back
The vastness and complexity of the ETF market may seem overwhelming, but as a Register Investment Advisor and fiduciary, APCM understands that you can’t always judge a book by its cover – or in this case, an investment by its liquidity. Our team is dedicated to researching which investments are the most cost-effective and efficient, while still enabling you to reach your goals.
ETF Basics: The Creation & Redemption Process
Debunking Myths About ETF Liquidity
Understanding ETF Liquidity