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.



However, in cases where underlying liquidity is limited, either because of limited access or liquidity—you tend to see these limitations materialize in the premiums and discounts experienced by those trading shares of the ETFs.

For example, let’s look at an ETF such as the Market Vectors Indonesia Small Cap ETF (NYSEArca: IDXJ). The fund has an underlying volume/unit measure of 8.77 percent.

In essence, if I needed an AP to create 100,000 shares of the ETF on my behalf, that creation alone would account for over 17.5 percent of the volume in the underlying securities. Also, consider that only a limited few of the 45 APs have direct access to the Indonesian markets.

Sure, they could opt for a cash creation, but in that process the AP is essentially handing over the buying of those underlying securities to a third party that isn’t primarily concerned with getting the best price for them.

As a result, something like IDXJ can see a significant premium or discount, not simply as a result of stale iNAV or NAV pricing, but also because APs will have to charge a premium for the risk of executing the trades—especially in a situation where’s there’s less competition among market makers due to lack of access.

So how does all this apply to all the problems with exiting fixed-income positions that journalists and bloggers are so worried about?

Interestingly enough, State Street Global Advisors tinkered with aspects of underlying liquidity. A few weeks ago, the firm halted cash redemptions in its fixed-income ETFs. As a result, APs that had to redeem ETFs as they were buying them back in the primary market were given the actual underlying bonds to sell in the secondary markets. That’s a huge burden on the AP.

Not only does the AP have to account for slippage in selling the bonds, but it’s likely the group of APs willing to do such redemptions was smaller than the normal group accustomed to cash creations. As a result, investors saw significant discounts.

However, the benefit of the in-kind redemption process is that investors currently invested in the ETF are protected, while the APs—and consequently those selling the ETF—bear the burden of the exit costs.

The key point here is that ETFs may offer liquidity, but that liquidity often comes at a premium that expands during times of market volatility as a result of issues that begin in the underlying markets.

Also, to believe that ETFs are becoming the true market is an oversimplification.

Unlike futures contracts that can settle in cash, with ETFs, at some point someone has to deal with the liquidity of the underlying markets.

At the time this article was written, the author held no positions in the securities mentioned. Contact Ugo Egbunike at [email protected].


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