Live Chat: Liquidity As A Factor?

June 14, 2018

[Editor's note: Live Chat! with Managing Director Dave Nadig happens Thursdays, with the question window available in the morning.]


Dave Nadig: Howdy folks, welcome to the Live Chat!
You can ask questions in the box below, and we'll post a transcript later this afternoon if you have to hop off for some reason.
Last: don't miss the weekly podcast at, where we also cover some hot topics each week in a live format.
So, housekeeping done, let's get to the questions!


Ben F.: Hi Dave. What do you think of liquidity as a factor? Not sure I'm buying it.
Dave Nadig: Starting off with a nerdy one! Love it.
So, MSCI has been tracking liquidity as a factor for about a decade if I recall right -- and to sum up, it's the risk associated with how well something does or doesn't trade.
They've published research showing that more liquid stocks tend to perform better than less liquid stocks, particularly in strongly upward-trending markets.
So it's reasonable to ask the question: is this really a "factor" on its own, or is in fact "liquidity" just giving us a kind of blended proxy of momentum and size?
That's probably why you're "not sure you're buying it," and to be honest, I'm kind of right there with you.
I haven't seen the study yet (it may exist, and I just haven't read it) that proves to me that liquidity is really its own effect.
I believe it more in inherently illiquid markets (like bonds) but that's not what we're talking about here.
ALL that said: it's not a part of any big ETF or index yet where we can point to a live track record and say "see!" one way or another.
But it is one of the factors in the MSCI FaCS suite of analytics (which we'll be featuring at in the fall) -- so it will be interesting to see how different funds measure up.


Alex L.: How and why do big funds like IEMG trade millions/billions of dollars daily and end up with no net flows? (Eric Balchunas of Bloomberg has been tweeting about it here):

Dave Nadig: I think that's our first multimedia question!
So, when you see a fund like this, it means one thing -- buyers and sellers are essentially matched. There's just not enough momentum -- good or bad -- for one side of the trading pool to overwhelm the other.
You need that kind of "swamping" one side of the book in order to create a big enough price differential to trigger creation/redemption activity.
That gap needs to be bigger for something like IEMG than it does for something like, say, SPY, precisely because so many of its holdings are either not trading in the same time as the U.S. markets, or because they're less liquid.
So - lots of trading keeping spreads tight naturally, not a huge exogenous pressure from momentum = low arbitrage opportunities = no creation/redemption activity.
One other BIG factor:
The creation unit size of IEMG is ENORMOUS - it may be the largest, period.
It's 600,000 shares.
That means you need a dollar balance of $30 million to do a create. That's a BIG chunk.
So that means you need not just an arbitrage opportunity, but a huge, sustained arbitrage opportunity.
Great question.


Bailey Ferguson: How can some "gurus" be so pro blockchain and others be diametrically opposed to it?
Dave Nadig: Heh. Great question. I think Drew Voros pointed out to me the other day that the 52-week spread on bitcoin was roughly $1000-$20,000
and it's currently around, what, $6,000.
When you see that kind of uncertainty about what something is worth, it's absolutely inevitable that you end up with just as wide speculation from pundits.
By definition, SOME of them will be right, and then you'll just end up with a survivor bias problem. We'll only remember the ones who made the "call" for it to go to $50K or crash to $50.
But they'll get to be geniuses for a little while.
That's bitcoin. Not blockchain (a key distinction).
But a lot of the smarter discussion is around using blockchain as a ledgering technology totally removed from the cryptocurrency stuff.
And I tend to personally be in the "not a big bull on bitcoin, but think blockchain is interesting" camp.
Which I will admit is a bit of the coward's camp. The easy answer.


Roger Barnum: Is there a difference between factor investing and smart beta investing? Or just semantics?
Dave Nadig: I think this is mostly semantics -- there's no good definition of "smart beta"
Rob Arnott from Research Affiliates says smart beta is anything that breaks the link between weight/presence in an index, and the security's price.
Which means that (for example) equal weighting is smart beta, but momentum is not.
It's as good a definition as any, I suppose, but ultimately, all smart beta is at some level based on factor analytics (that I've seen) - it just depends which factors and what you do with them.
So I wouldn't get hung up on the label, and just focus on what you own and why you own it.
If it happens to be a factor, so be it. If it happens to be active management in smart-beta-clothes, so be it.


Anonymous: Do the currency-hedged ETFs have significant counterparty risk? Are the currency hedges swaps? The Deutsche Bank headlines made me think to ask.
Dave Nadig: Super interesting question with some nuance to it.
The short answer is really "no," but the long answer is slightly more complicated.
Let's just take the euro for instance.
The big fund there is FXE, from Invesco.
So, it is essentially just a bank account
it just owns euros.
The problem is -- at the size firms like this have accounts, a lot of the cash is actually NOT insured.
It's not like the FDIC runs up to $300mm in deposits.
So in this case, if in fact JPMorgan Chase went completely bankrupt, FXE shareholders are in the same boat as any other depositor.
So the question you have to ask is, how likely do you think a "surprise" bankruptcy is?
Just like, say, an exchange-traded note.
This is actually a systemic problem with institutional investing. It turns out owning lots of cash is very hard.
Which is why we have things like money market funds, and also part of the reason you can end up with paradoxical things like negative interest rates on German bonds.
Institutions often simply HAVE to own securities, because they can't sit on the cash.
So the short answer is "no" because I think the risk of surprise defaults is very low.
But it's "maybe" because it's certainly not ZERO.


L. DiCaprio: I know that volume reduces spreads, but why? Is there any data that points to this or is it just a concept we all agree to?
Dave Nadig: Loving the nerdy questions.
So, there is no systemic link between volume and spreads, which is what you are getting to. When you see that XYZ traded a million shares yesterday, that doesn't mean spreads HAVE to have been tight yesterday.
And in fact, if that million shares was a single negotiated trade, spreads might have been wide.
But historically, high-volume securities of any asset class tend to BE high volume not because of whales, but because of lots and lots of minnows. Many many small trades.
When you have many, many small trades, they will naturally compete with each other for execution, and that drives down the inside spreads. 
Even in giant securities like SPY, the "inside" is quite often very small -- 100 shares on the bid or ask, with the big available limit orders just outside that inside edge -- which will be constantly moving as orders get executed.
Volume is a useful proxy, because it's easy and available.
But what you as investor should really care about is your actual arrival cost to buy or sell, which includes your expected spread and your trading costs, and any market impact you might make (we should all be so lucky).


Holly Thurman: Can mutual funds hold ETFs? And is the reverse true?
Dave Nadig: It's actually a bit tricky here.
So yes, they can (in both directions) and in fact they do (in both directions) but there are diversification issues.
There are some very large ETFs that basically just own other ETFs
QAI, for instance, the IQ Hedge fund tracker, only owns other ETFs under the hood.
That is essentially a mutual fund owning ETFs.
But they can't just own, for example, ONE ETF, because the IRS rules on diversification mean they have to spread it around.
But it's actually quite common to see the cross holdings.


Terrance Davenport: Several outfits publish annual surveys on ETF use. I assume they ask fairly similar questions. Are you noticing any significant differences in their results?
Dave Nadig: HI Terrance, there was actually a great one just last week from Schwab: 
For those of us that track this day in and day out, I will say we tend not to see big surprises.
ETFs get used more and more by younger investors, they get used because of cost and brand recognition.
There are nuances, but sure, a lot of the headlines are obvious.
What we do occasionally see, however, is some interesting trend-shifts.
For instance, ESG is "all of a sudden" a bigger issue than anytime I can recall in my career. We saw that start bubbling up the surveys in the past few years.
So I still find them all valuable -- both the ones we've done with advisors here at, and the ones I read from other industry groups.
It may be a bit navel-gazy, but I think it's interesting.


Anonymous: Why are so many Vanguard ETFs seeing such huge inflows right now?
Dave Nadig: Well, in a word, cost.
The ETF flows story has been almost overwhelmingly about people abandoning high-cost underperformance in favor of low-cost beta.
Some of the high cost is active, sure, and a lot of the low-cost is plain-vanilla indexing.
Vanguard has been in that game for a very long time, so the trend has really been their friend.
As a firm, they've also been very cautious in product launches historically, so when they DO launch something new, investors who are already Vanguard loyalists seem pretty willing to pile in.


Jon R: What are your thoughts on ETFs powered by AI? Is this the future, or a flash in the pan?
Dave Nadig: So back in my day (get off my lawn) we just called these "quant strategies."
But in all seriousness, really, the whole "AI" thing just means "we have a fancy way of training our black box."
I am inherently skeptical of black boxes, and I think that's a healthy thing.
It's not that they CAN'T do what they say -- of course some will.
But I worry about about things like machine-learning systems, because almost by definition, it's automated data-mining, and one thing we know about finance is that often what worked yesterday isn't going to work tomorrow.
So I find it all very intriguing, and I love reading the research, but I'm not convinced that, as a class, AI will just systematically be "smarter" than the pricing mechansims of the market.
OK, last question.


Elphaba: The actively managed factor funds from Vanguard have been pretty dormant since their launch. Why do you think that is?
Dave Nadig: Man, aren't these interesting products?
From Vanguard of all people - actively managed factors.
A few things. First, the main reason I think these funds are active is so that they can adjust their portfolios' fluidly without having an insanely complex rule set.
Meaning -- if a stock drops off the momentum screen on a Tuesday, the fund doesn't have to wait for a month to "rebalance" it out of the Momentum portfolio.
So that means a few things.
Unstable portfolios, and a truly active track record.
They're not appealing to just a normal Vanguard low-cost investor from the previous question.
I think that means you're going to see a real wait-and-see attitude by investors - just like investors tend to have around any active manager.
But, I think Vanguard is in this for the long haul.
They just don't shut products down very often.
So maybe it takes a year, maybe it takes 3, but these funds will ultimately live or die based on their performance vs. other issuers' low-cost passive factor funds.
It's a super interesting -- and somewhat odd -- position for Vanguard to be in. But I wouldn't count them out.

OK, that's going to wrap this week. As always, a transcript will be up shortly.

We should be on for same time next Thursday.

Thanks everyone, and see you next week.

Find your next ETF

Reset All