Analysing True ETF Market Liquidity

When the news broke this year that the annual volume of ETFs traded on the NYSE was more than $18 trillion and exceeded the GDP of the U.S., it was game on between the ETF naysayers and yea-sayers.

In particular, the SPDR S&P 500 ETF (SPY), the iShares Russell 2000 ETF (IWM), the Powershares QQQ Trust (QQQ) and the iShares 20+ Year Treasury Bond ETF (TLT) would typically account for $13 billion of that volume per day.

Life Was Simpler In The Past

The complexity of understanding the stock market as a dynamic system is a mammoth task and one needs to factor in the impact of huge volumes of ETF flows. Yet in 1991 when physicist Doyne Farmer and his fellow researchers at Prediction Company were deconstructing equity markets, they didn't need to grapple with the central role that ETFs would play in the years ahead. It was a hard enough problem dealing with one order book, let alone needing to factor in the primary and secondary ETF market.

By 2015, the noise around the topic of ETF liquidity was getting deafening.

50 days of intraday SPY pricing – Source, Bloomberg 2.10.15

Yet the noise did not manage to drown out the chaos that ensued on 24 August, when some of the best known ETFs gapped down 30 percent or more.

The doom mongers predicted failure in the high yield market. Little did they know that it would be large cap equity ETFs that would be hit the hardest. This particular occasion proved to be the first test of the new volatility limits that were imposed by the regulators after the 2010 flash crash.

You could say this episode was something of an embarrassment. At least the global head of iShares, Mark Weidman, thought so, as he recently told the readers of the Wall Street Journal that "the test didn't go well".

303 Seconds To Avert A Real Crisis

On 24 August, SPY, along with other ETFs, experienced so many sell orders the NYSE could hardly cope. The anti-ETF brigade were preparing their pick nick for a field day.

But their euphoria wouldn't last long: data provided in a recent Wall Street Journal article suggested that the arbitrage between the price of a major iShares ETF and its underlying basket of stocks on 24 August had vanished after just 303 seconds. This means the fund experienced dysfunctional trading three seconds over five minutes.

If the same time frames were applied to unit trusts, which can trade at a significant premium or discount for weeks and months, then that would surely be worthy of a headline.

And on the point of other investment vehicles – for most of 2015 the concern of liquidity seemed to only to pertain to fixed income ETFs and bonds. Yet when Apple, one of the most liquid stocks in the world, announced their results on 21July, all hell broke loose as the stock fell nearly 10 percent. So much for liquidity being on the universal investor's wish list.

Allan Lane is managing partner of Twenty20 Investments