ETFs Made Easy: Implied Liquidity

Sometimes it’s what’s under the hood that matters. Sometimes it’s not.

Reviewed by: Dave Nadig
Edited by: Dave Nadig

If you’re coming to ETFs from a traditional mutual fund background, the “exchange traded” part of the acronym can be what trips you up. ETFs trade like stocks, and that means you have to use basic-trading common sense to make sure you don’t have any surprises. That means using limit orders, making sure you take commissions into account when figuring out how much your investments cost.


But not all ETFs trade like the SPDR S&P 500 (SPY | A-98)—the most liquid security in the world. SPY trades $26 billion a day, so it’s safe to say you can enter in almost any size trade and not worry about whether you get your execution, or what fair value is.


Importantly, SPY isn’t just trading a lot every day (what’s called “on-screen” liquidity), the underlying stocks are some of the most liquid in the world. Even the smallest S&P 500 company, midcap Diamond Offshore (DO), trades 2 million shares a day. That’s what we mean by “underlying liquidity”—how liquid the holdings of an ETF are.


Under The Hood

Why should you care? Consider the least liquid competitor to SPY, the SPDR MFS Systematic Core Equity (SYE | C-78). SYE is an actively managed ETF with just 42 holdings. On an average day, not even 200 shares will trade hands. It’s essentially impossible to trade 1,000 shares without a lot of work. But if you wanted to trade 50,000 shares, you wouldn’t have much problem.


Why’s that?


Well 50,000 shares is a creation unit—it’s the size that an authorized participant needs to go to the issuer, State Street, with. So if you want 50,000 shares, the AP will bundle up a pro-rata share of the 42 individual stocks in the portfolio, deliver them to State Street, who will make new shares and hand them back to you.


It really doesn’t matter what the on-screen liquidity is, because you’re not trading on the screen. What matters is how hard it is to get those 42 stocks, and in this case, those 42 stocks are just as liquid as the S&P 500 holdings.


We measure this every day on our fund reports with a metric called “underlying volume/unit.” That measure asks “how much of the average day’s volume will I be in the underlying holdings if I do a creation?”


The answer for SYE is 0.04 percent. Essentially nothing. That means that while 1,000 shares of SYE is tough, 50,000 shares—if you work with a trading partner who can make new shares—is easy.



There are plenty of funds where the opposite can actually be the case ...




In the Global X MSCI Nigeria ETF (NGE | F-89), for example, 1,000 shares isn’t that impossible—it trades about 25,000 shares a day. The spreads will be wide, but you can get the trade done.


However, 50,000 shares will be very tricky. Underlying volume/unit for NGE is 6.06 percent. That means one creation unit will have the AP scrambling to be over 5 percent of all the trading activity in those underlying stocks today. That’s enough to move the market.


It also means that it’s hard for the AP to do its job, so he or she will be likely to let the ETF trade well above fair value before the AP even steps in to make new shares—that shows up as a premium in the market price to its NAV.


When people want out, they’ll also let it trade to a discount before they start buying with an eye toward redeeming. In fact, if you look at the premiums and discounts for NGE, that’s exactly what you see.




What’s It All Mean?

If you’re trading small lots, for the most part, you can stay focused on the on-screen liquidity. But even if you’re only buying 100 shares, it’s good to know whether or not you can expect the ETF to trade at fair value if there’s a news event related to that ETF that makes volumes perk up.


We’ve seen big ETFs in illiquid markets—high-yield municipal bonds, for instance—trade to big premiums and discounts when the underlying markets get frothy.


In other words, underlying liquidity is always important—no matter how small you are.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.



Prior to becoming chief investment officer and director of research at ETF Trends, Dave Nadig was managing director of Previously, he was director of ETFs at FactSet Research Systems. Before that, as managing director at BGI, Nadig helped design some of the first ETFs. As co-founder of Cerulli Associates, he conducted some of the earliest research on fee-only financial advisors and the rise of indexing.