What is an ETF? — Part 13: True Liquidity

May 29th at 8:00am by Tom Lydon

Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 12: Exchange Traded Notes]

Advisors, institutions and retail investors have had certain notions on the ability to execute an optimal trade based on the perceived liquidity of a specific exchange traded fund. For instance, in regard to issues of liquidity, what has been used to determine a stock’s liquidity can’t be applied to ETFs.

Attributes such as trading volume and assets used to be major considerations for investors because investors would think that low activity in a fund would lead to wide spreads, bigger costs and, in a worst-case scenario, no one there to buy the fund shares you’re holding when you’re in the market to sell it.

If you’re an advisor concerned about liquidity in low-volume ETFs, you’re not helpless. Among your options is using the services of alternate liquidity providers. The providers facilitate ETF trades by providing a market for even the most thinly traded fund, and they’re opening up new worlds for advisors and investors, making it possible for individuals to invest in ETFs that they once feared would be illiquid and diversify into other areas of the market. The services of liquidity providers give advisors better access to price discovery and execution, without making a large impact on market prices.

A more apt interpretation of liquidity in ETFs would be to look at an ETF’s average trading volume and the average daily trading volume of underlying securities. ETF liquidity is based on everything that is inside the index or basket that the ETFs track since the funds are also shareholders of their underlying stock components.

While not on the low end of the perceived liquidity spectrum, good example of this concept is the recent explosion in the PIMCO Total Return ETF (NYSEArca: BOND). The ETF originally launched with $100 million in assets priced at $100 per share. Now, the fund has over $1 billion in assets but has only appreciated to about $104. If this were a stock that has gather over $900 million in a couple of months, the stock would probably not be priced at around $104.

With the help of alternative liquidity providers, investors may efficiently move large, bulk trades in small and large ETFs, without worrying about their price impact on the ETF.

For past stories in this series, visit our “What is an ETF?” category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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