ETF Liquidity Explained

February 17, 2010

ETF Liquidity Explained

Exchange-traded funds have enjoyed tremendous growth over the past decade, whether you measure that by daily trading volume, the number of annual new fund issuances or assets under management.

Assets under management have grown during the past decade from less than $100 billion to nearly $800 billion. Trading volume has soared as well: In 2009, the value of ETFs traded on U.S. exchanges surpassed $18 trillion, and ETFs regularly accounted for 30 percent or more of all dollar volume traded on U.S. exchanges. Meanwhile, over the past four years, we have seen between 100 and 200 net new funds per year.

Despite all this growth, flaws in the understanding of how these vehicles trade—and the best manner in which to trade them—remain. A variety of heuristics exist for determining which funds can be safely traded and which are too expensive for practical trading, but nearly all of these rules of thumb are flawed at best and dead wrong at worst.

One of the most common assertions is that investors should avoid any funds with fewer than $100 million in assets and average daily trading volume of fewer than 100,000 shares. This paper will show that there is virtually no correlation between those two factors and the true liquidity of an ETF.

For purposes of this paper, Fox River Execution defines the true liquidity of the ETF to be the combination of the ETF’s average daily trading volume and the average daily trading volume of the underlying securities. The combination of these two factors explains the real-world experience of traders moving significant sums of money into and out of funds.

Most of the detailed examples reviewed in this paper involve ETFs with U.S. equity underlying securities because there are fewer variables to interfere with the precision of the calculations. However, as shown, this general framework can be used to both analyze and understand the trading patterns of ETFs based on currencies, commodities, fixed income and international equities.

Brief History Of ETF Growth

The story of the growth of the ETF market has been one of innovation meeting opportunity repeatedly, but not necessarily immediately. It often takes a high-stress period in the market for investors to realize that there are new ways to use the tools at hand.

On Jan. 29, 1993, State Street Global Advisors brought to market the first ETF—the SPDR S&P 500 (NYSE Arca: SPY)—to almost no fanfare. On its second anniversary, SPY was trading 50 percent less volume than it did in its first month of existence, and even that was not that impressive. It was not until late 1995 that it began its uninterrupted march to trading volume leadership.

One theory as to why volume was so light is that the applications State Street envisioned for the product did not resonate with investors or traders. Their sales pitch included asking S&P 500 Index fund managers to replace their 500 stocks with a single security. That was not an appealing prospect to managers, as it represented an effective outsourcing of their fund management responsibilities (with a resulting second level of fees charged to the end investor).

It was not until 1999 that the market for ETFs began to really heat up. 1999 was the year that the Nasdaq-100 QQQs became known as the proxy for technology stocks. With the Internet stock bubble at full inflation, investors could not get enough of the QQQs. For ETF issuers, an entire new market was discovered: the day trader. Issuers responded to the new demand with a then-record 57 new fund launches in 2000 (see Figure 1).

ETF Liquidity Explained

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