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Don’t Let ETF Perceived Liquidity Concerns Scare You Away

The U.S. exchange traded fund industry has accumulated over $2 trillion in assets under management, but the majority of assets remain allocated toward the largest offerings, potentially causing investors and advisors to miss opportunities in smaller or lesser known ETFs.

"The next time you are looking for an ETF solution to solve a client's needs, do not eliminate what may be the best solution simply because of how little it trades," Brandon Clark, director of ETF product management at Legg Mason, writes on InvestmentNews . "Talk to the ETF sponsor about liquidity. Most can quickly assess how it matches both your client's investment goals and liquidity needs. A little time and discussion could make the difference in the success of your client's investment plan."

While investors should be wary of risks associated with an investment's liquidity, financial instruments do not all work the same, which can cause investors to focus on the wrong things, Clark warned.

Instead, Clark believes advisors and investors should keep investment exposure as their main priority.

"Making trade-offs between 'low-volume' ETFs that fit your clients' needs, and 'high volume' products that can compromise clients' needs could be the difference between their success or failure," Clark said.

Potential investors should also keep in mind that new ETFs with innovative strategies all start out with low assets and trading volumes in the beginning months as more people become aware of the products. ETFs that show huge trading volumes now started off as relatively unknowns when they first came out.

Currently, over 90% of ETFs trade less than 500,000 shares per day and 75% show less than 100,000 shares per day. Nevertheless, these same low volume ETFs may still have millions in assets under management.

"The reality is most clients use ETFs as asset allocation tools, not trading vehicles," Clark added.

Looking closer at ETF liquidity, investors have to understand that ETFs represent a basket of underlying securities and the underlying stocks continue to actively trade in the market. While an ETF may exhibit low trading volumes, trading activity in underlying stocks can be leveraged by market makers or Authorized Participants to facilitate efficient trade orders, potentially creating greater liquidity for the ETF .

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"Regardless of the ETF's average daily volume, in normal market conditions many client ETF trades can usually be quickly facilitated, small or large," Clark said.

However, once people start asking for large block trades or more illiquid asset classes, advisors and investors should start putting together a plan of attack. For instance, large investors can work with a knowledgeable ETF trading desk to maximize an ETF's liquidity.

Clark suggests large investors should follow some simple practices to seek fair execution and access the full potential liquidity when buying and selling ETFs, including the use of limit orders, the utilization of a broker's block desk and avoidance trading at a market open.

Market orders and stop orders have caused investors to execute trades at prices well beyond their targets. Instead, a limit order, which buys or sells a set number of shares at a specified price, avoids many pricing problems.

A broker's block desk helps investors get in touch with experienced traders to efficiently manage an ETF's underlying liquidity quickly and work with market makers.

Lastly, market opens are typically volatile, which can potentially have a negative impact on execution quality.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article was provided by our partner Tom Lydon of etftrends.com.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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