Illiquidity Concerns May Be Unnecessary With Smaller ETFs

Advisors interested in incorporating new ESG and other specialty ETF strategies into their clients’ portfolios may have concerns about the size of the fund and its potential illiquidity. ESG and specialty funds like thematic ETFs can often have smaller amounts of assets under management, especially when they are new. However, these concerns may be unfounded. A fund’s size should not necessarily hinder achieving the desired exposure.

In this article, we will explore why advisors may not need to worry about illiquidity regarding ESG and other specialty ETFs. We will also offer some tips on how to mitigate any potential issues.

Liquidity of New ETFs

First and foremost, it’s important to understand that ETFs, in general, have a liquidity advantage over other types of vehicles. As Todd Rosenbluth, head of research at VettaFi, explains, “The true liquidity of an ETF is the holdings inside. An ETF that invests in large-cap securities is more accessible than the ETF’s average daily volume. New shares can easily be created, but advisors must work with their block desk for best execution.”

See more: “A Shift to Quality Is Not a Political Statement on ESG but the Market

First of all, ETFs are generally more liquid than many other investment vehicles, regardless of their size. This is because ETFs are intentionally designed to be as liquid as their underlying holdings. For instance, if an ESG ETF invests in large-cap securities, which are generally more liquid, then the fund is likely to be highly liquid despite the fund’s average daily volume. Similarly, many thematic ETFs hold large allocations to FAANG stocks and other large-cap tech stocks. These ETFs may have higher liquidity based on their holdings, even with only a few million in assets. ETFs also benefit from a robust ecosystem that supports their accessibility. They have authorized participants and market makers who are instrumental in maintaining liquidity. They do this by creating and redeeming shares as needed, which helps keep spreads tight. It’s important to remember that ETFs are not traditional mutual funds and utilize distinct mechanisms to manage liquidity.

Potential liquidity risks may still exist, however. One of the main risks is that the fund may not be able to meet redemption requests promptly. This could occur if there is a sudden change in demand for the fund.

How do you mitigate risk? 

Advisors can take steps to reduce this risk by collaborating with a block desk to achieve optimal execution. A block desk helps align client investment objectives with market conditions by providing full-service execution coverage, trading strategies, and liquidity sources. Additionally, block desks offer educational resources and post-trade reviews to help RIAs expand their knowledge and avoid errors. By partnering with a block desk, advisors can secure the best possible price for their trades and ensure timely execution. This approach is a proactive way for advisors to mitigate risk and increase their chances of success.

In addition to working with block desks, advisors can work with capital markets teams at issuers to make trades in smaller or newer ETFs without moving markets. These teams can provide valuable insights into the liquidity and trading dynamics of the ETF. As well as offer guidance on how to execute trades in a way that minimizes market impact. By working closely with these teams, advisors can ensure they are getting the best execution possible and can access a broader range of ETFs for their clients. This can help to enhance diversification and potentially improve returns over the long term.

See more: ESG ETFs Are Highly Liquid”

Another way to mitigate the risk of illiquidity is to diversify across multiple ETFs that offer similar exposures. Advisors can spread their risk and avoid overexposure to any one fund by investing in multiple funds. This can help to minimize the impact of any potential liquidity issues and ensure that clients’ portfolios remain well-diversified.

Do advisors need to worry?

Advisors interested in incorporating smaller funds into their clients’ portfolios do not have to let that prevent them from gaining exposure to a particular strategy they are interested in, whether it be an ESG, thematic, or some other type of specialty fund. The funds may be more liquid than their trading volume suggests, thanks to the liquidity of the underlying securities and the fact that they are traded on exchanges. However, it’s still important to be aware of the potential risks and to take steps to mitigate them. By working with a block desk and diversifying across multiple funds, advisors can help to ensure that their clients’ portfolios remain well-diversified and well-protected.

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