Don’t Fear the Boogeyman of ETF Liquidity

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By David Mann, Global Head of Capital Markets Exchange Traded Funds (ETFs), Franklin Templeton

Selling an exchange-traded fund (ETF) should be as easy as buying one, regardless of the size or volume of the fund. David Mann, Head of Global ETFs Capital Markets explains why investors need not fear an unknown future event when making their investment decisions today.

This blog/newsletter covers a wide range of ETF-related topics, but the topic we feel compelled to return to is liquidity. This topic was covered in my very first post (“What investors look for in an ETF”) on misconceptions about using trading volume to determine ETF liquidity as well as my most recent on the best ways to keep score (“Moneyball: The Art of Analysis in ETF Trading and Liquidity “). In the meantime, there have been dozens more.

I tend to focus my articles on specific elements of the ETF liquidity narrative so investors keep an open mind when selecting an ETF beyond those with the most volume or assets. .

There are many examples and case studies within the industry to support this claim. However, there is one refusal that we sometimes receive that can be difficult to counter: Will liquidity be there when it comes time to sell?

I consider this the “Boogeyman” of ETF liquidity. “Oh sure, it’s easy for me to buy this ETF today, but how do I know I can sell my position later?” The challenge is that any example of an investor selling their ETF positions with minimal market impact comes from the past and do not expect an unknown market event on an unknown day in the future. How do you refute an event that didn’t even happen?

Moving on to the conclusion, selling an ETF should be as easy as buying one, as there is nothing inherent in the structure of the ETF that would make selling more difficult than buying.

What if there are no buyers? !

I guess the Boogeyman himself – investors’ main concern – is that there will be no buyers when they want to sell. The good news is that a good understanding of ETF arbitrage can show why this concern is unwarranted.

ETF liquidity providers do not want to take directional bets in the market. Their business model is to determine an ETF’s “fair value” based on the price of the underlying securities, provide a two-sided market around that value, and then hedge their risk accordingly based on the amount of purchases and sales.

There’s no need to worry about whether there will be buyers someday in the future because we don’t really need buyers (in the traditional sense)!

When investors are looking to sell, ETF market makers simultaneously buy the ETF and sell the underlying basket (or other highly correlated security). Similarly, the same dynamic would occur the other way around with ETF market makers selling the ETF while buying the underlying basket.

Can market uncertainty overwhelm the normal ETF arbitrage mechanism?

As always, I will add a caveat. ETF trading works like this almost All the time. The reason I say “almost” is that we have seen a few rare instances over the past few years where market uncertainty overwhelms the normal ETF arbitrage mechanism.

We saw it in March 2020 (The “new normal” for ETF trading? ») and then earlier this year with some ETFs that hold Russian stocks (Empty the inbox: ETFs that only hold Russian stocks”).

In times of extreme market uncertainty, the ETF arbitrage mechanism for everything ETFs are impacted, regardless of their size or volume. This was the main takeaway from the International Organization of Securities Commissions’ 2021 report that highlighted ETF trading behavior in March 2020 (“The Liquidity Unicorn: Are ETFs Really Hot?” bulletproof during market stress?”).

No ETF is immune to such conditions – even billion-dollar ETFs with hundreds of millions of daily trading volumes have experienced excessive net asset value discounts.

The boogeyman of ETF liquidity who thinks there might be trouble selling an ETF on a random day in the future doesn’t exist (even if you chant his name three times!). The real concern is the occurrence of a market-wide event causing undue uncertainty for all ETFs.

What are the risks ?

All investments involve risk, including possible loss of capital. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those that offer the potential for higher returns come with a higher degree of risk.

For actively managed ETFs, there can be no assurance that the manager’s investment decisions will produce the desired results.

ETFs trade like stocks, their market value fluctuates and may trade above or below the net asset value of the ETF. Brokerage commissions and ETF expenses will reduce returns. ETF shares can be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no assurance that an active trading market for ETF Shares will develop or be maintained or that their listing will continue or remain unchanged. Although ETF shares are tradeable in secondary markets, they may not trade easily in all market conditions and may trade at significant discounts during times of market stress.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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