A new study about exchange traded funds (ETFs) tries to shed light on how common notions of liquidity in ETFs are not determinants on the true liquidity of an ETF. By having the right know-how, an investor may move large positions through the ETF market with relatively little impact.
It is most commonly asserted that investors should avoid funds with fewer than $100 million in assets and average daily trading volume of lower than 100,000 shares, comment Paul Daley, Phil Dorencz and Dan Bargerstock for IndexUniverse. But is it really that simple? For their study, they try and define true liquidity of ETFs as a combination of the ETF’s average daily trading volume and the average daily trading volume of the underlying securities. [Creation and Redemption Explained.]
ETFs are said to trade in an arbitrage or derivative market. The value of ETFs come from the value of the securities that underlie them. Underlying securities have values that are determined in an outright market, and the ETF’s value is expressed in relation to those securities. Deviation from the arbitrage-free price in the ETF provides an opportunity for profit to those savvy enough to take advantage of the deviation. [What Is ETF Liquidity?]
An ETF arbitrage process involves a creation/redemption process. Authorized participants, or APs, can “create” or “redeem” shares of the fund, thereby increasing or decreasing the number of shares outstanding in the market to accommodate shifting demand for the fund. APs create new shares of an ETF by swapping a basket of securities to the ETF sponsor for an equivalent value of newly created fund shares, and the AP can turn in ETF shares for securities. If the fund shares are trading at a discount to the fund’s net asset value (NAV), an AP buys the basket at NAV and shorts the fund shares above NAV at the same time. The AP would then exchange the basket for fund shares to cover its short position and lock in a profit.
For more on the results of the study, visit the story at Index Universe.
For more information on ETFs, visit our ETF 101 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.