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More than meets the eye

MARK VAN METER, CFA 28-Dec-2020

Glacier

Developing new ETFs with strategies that can help individual investors progress on their goals is one of the more satisfying aspects of this business. We’ve been successful in launching an array of volatility-weighted ETFs, dividend-focused strategies, and more recently, various thematic strategies. These are all tools that help investors navigate our ever-changing investment backdrop.

 

However, when I’m presenting and discussing the risks and potential benefits of our new ETFs, many financial advisors ask about assets under management and liquidity in these products. Those are fair questions. After all, real-time pricing and the ability to trade in and out of ETFs are some of the basic features that have made all ETFs popular.

 

That said, there seems to be a misperception that any new ETF with low average daily trading volume lacks liquidity. That’s just not the case.

 

In fact, many newly minted ETFs offer deep liquidity, much of it unseen on a typical trading screen. Average daily volume (i.e. the number of shares traded on an exchange) is not the ultimate representation of an ETF’s liquidity. Rather, it’s an incomplete figure, and sizable ETF trading activity may actually be taking place off exchanges altogether. Sometimes called OTC trading (over-the-counter), this activity is generally not reflected in the volume data provided by stock exchanges. Thus, without seeing consolidated trading information, you can’t accurately assess an ETF’s true daily trading liquidity.

 

ETF trading also uses on an authorized participant (AP) to create and redeem additional shares on an ad hoc basis based on demand. Among other things, the ability to create new supply of ETF shares can help keep bid-ask spreads narrow. Understanding that there are multiple layers of liquidity and knowing that your ETF sponsor has both the experience launching new products and the relationships with capable APs is far more important than average daily volume.

 

The other misconception I often run into is the notion that placing a large buy or sell order for a new ETF automatically disrupts the market. Not so. Ultimately, liquidity is not based solely on the number of ETF shares traded, but rather on the underlying securities that are held by the ETF and the frequency with which those are traded. So, if a new ETF tracks an index of liquid securities, it’s likely to have ample liquidity and be able to handle sizeable trades with ease.

 

The perception that it’s too risky to buy newly issued ETF is naïve, in my opinion. If a blanket statement like that were applied universally it would preclude investors from benefiting in any innovative product. As always, due diligence is recommended, and it’s best to know who stands behind the investment and whether the sponsor has the experience and relationships to provide adequate liquidity.