ETFs Aren’t The True Market

July 15, 2013

There’s more to ETF liquidity than meets the eye—and it’s crucial to grasp it all to truly understand ETF trading.

In the last few weeks, ETF trading and liquidity issues have been in the spotlight. There’s much to be discussed—and underlying liquidity is central to that discussion.

In his recent open letter to investors, Global Head of iShares Mark Wiedman made a clear distinction between the primary market for an ETF (ETF share liquidity) and the secondary market of an ETF (liquidity of underlying securities in a fund). However, there’s one line in that letter I simply can’t swallow: “more and more ETFs are becoming the true market.” If anything, that line should have a HUGE asterisk next to it.

Indeed, there are times when specific ETFs can provide price discovery, but in no way should we assume that ETFs are becoming the true market. Rather, we need to understand where ETF liquidity is limited; namely, the underlying liquidity.

In the media circus regarding the flaws of ETFs, the focus has really been on trading of fixed-income ETFs. However, the fixed-income ETF space is particularly complex because of issues relating to how net asset value (NAV) and indicative NAV (iNAV) are calculated.

In the fixed-income space, NAV is calculated off the bid of the underlying issues, and is stale after underlying bond markets have closed. This is one reason why investors have seen such a disconnect between ETF share prices and NAV values in recent weeks. However, to say this is the only reason doesn’t provide the full picture.

Underlying liquidity is really the first place to begin when understanding ETF liquidity. When I say “underlying liquidity,” I tend to think of it in two forms: the actual frequency of trading in the underlying securities, and the level of access to those underlying securities.

If you’re dealing with a particularly liquid underlying market, both in terms of volume and access, there’s a strong argument to be made that that ETF can indeed be a viable way to establish price discovery. But crucially, when either of those two components for underlying liquidity is limited, the argument for ETF price discovery becomes a bit flawed.

Something like SPY is a great example of this. It’s a fund that tracks the 500 largest companies in the U.S. All the underlying securities in SPY are liquid, trade during U.S. market hours, and are incredibly easy to trade for any one of the 45 authorized participants (APs) mentioned in Mark Wiedman’s letter.

Even a fund like the iShares MSCI Japan ETF (NYSEArca: EWJ) can be used for price discovery. Although the underling basket in EWJ doesn’t overlap during U.S. market hours, the level of access in the overnight markets is high for a majority of APs, and the liquidity in the underlying basket is more than adequate.

According to our measures, EWJ has an underlying volume/unit measure of 0.04 percent. This means that 1 creation unit of EWJ unwrapped into its underlying securities accounts for 4 basis points of the daily volume in those securities.

To put that metric into perspective, EWJ trades the equivalent of 100 creation units per day. So even on a day when every trade in EWJ can be considered an “inflow,” the AP responsible for creating new shares of EWJ would make up 400 basis points, or 4 percent, of the daily volume in those underlying securities—a drop in the bucket.


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