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February 4, 2021

Demystifying the Liquidity of ETFs

Liquidity is an important characteristic to consider when aligning security selection with investment objective. The need for capital protection and ability to convert an investment holding to cash is essential for shorter or unpredictable time horizons, but it is less important when investing for a retirement goal 30 years out. Investors may often evaluate a stock’s liquidity by its trading volume.  While this may be a starting point when looking at a common stock, it’s less effective when evaluating exchange-traded funds (ETFs), as it fails to take into account the structure behind the ETF that ensures its liquidity. The result is often a misunderstanding of an ETF’s liquidity and one of the most persistent myths in our industry.

 

For any security trading on the stock market, the price is simply the auction price agreed upon by the buyer and the seller. An investor looking to make a sizeable investment in a single thinly traded security would be justified in their concern of potentially moving the market, driving the price higher and resulting in a poor outcome. However, daily trading volume only provides a small indication of an ETF’s liquidity. Unlike a single stock, the supply of an ETF is open-ended; new ETF shares can be created and existing shares can be redeemed on demand. This structure not only maintains the pricing integrity and ensures trading takes place around the net asset value (NAV), it also provides a structure for liquidity. Thus, the liquidity of an ETF is much more than its daily trading volume.

 

The liquidity of an ETF is more accurately determined by evaluating the liquidity of its underlying holdings. Whereas daily ETF trading volumes reflect the trading activity of the security on the secondary market, the liquidity of the underlying securities may indicate how effective the ETF sponsor and market makers will be in the primary market when absorbing flows into an ETF.  This can sometimes be referred to as implied liquidity.

 

Implied liquidity is an indication of the liquidity of an ETF as a function of its holdings, rather than trading volume.  When an ETF is bought or sold, the buyer and seller are essentially trading a basket of the securities that make up a unit of that ETF product. As the basket must contain every security within the ETF, it can only be as liquid as its least liquid security. In other words, implied liquidity is an estimate of how much assets an ETF could absorb based on the liquidity of its underlying holdings, without having a bigger price impact on those securities.

 

 

ETFs

Single Stock

Price

Based on the value of the underlying portfolio (NAV)

Based on supply/demand of the stock

Supply of shares

Open-ended

Closed-ended

Primary source of liquidity

Trading activity of the underlying securities

Trading activity of the stock

Best measure of liquidity

Implied liquidity or daily trading volume of the underlying securities

Daily traded volume of the stock

 

The rise in popularity of ETFs is partly due to the added liquidity and transparency they offer over traditional mutual funds. Investors still gain the benefits of diversification while benefitting from the ability for intraday trading on the open market. The Canadian ETF industry now has over $250 billion in assets under management with over 1000 ETF products.1 This proliferation of ETF sponsors and products will undoubtedly result in some ETFs having a lower daily trading volume. To help investors avoid missing out on opportunities that may best serve their investment goals, it is more important than ever to fully understand the liquidity function of the ETF creation and redemption process.

 

Greater awareness around the processes that provide liquidity, and how to best trade ETFs and effectively navigate spreads will only increase adoption and help to continue to demystify the investment solution. As investors’ needs continue to become increasingly complex, education to simplify the products available and enhance the understanding of Canadian investors is to everyone’s advantage.

 

1CI Global Asset Management as at December 31, 2020.

About the Author

Randall Alberts


Randall Alberts

Blog author
CI Global Asset Management

As Senior Vice-President and Head of Distribution Eastern Canada, Randall works within the sales leadership group to design and execute CI Global Asset Management’s distribution strategy across all products and platforms. Randall leads the Eastern Canada sales team in supporting financial advisors and collaborating with strategic partners. A strong believer in the value of financial advice, he takes pride in helping advisors successfully navigate the challenges and complexities of modern asset management. Randall served as a Head of Distribution for WisdomTree Asset Management Canada, Inc. up until its acquisition by CI in February 2020. He brings extensive experience in the global asset management and wealth management industry having held senior sales positions and leadership roles at both BMO Global Asset Management and RBC. Having started his career as a financial advisor in 1995, first in a mutual fund dealership and later at a large IIROC brokerage, Randall brings a unique perspective and over 25 years experience in the financial services industry. Randall holds a Master of Business Administration (MBA) and a Chartered Investment Manager (CIM) designation.

Important Disclaimers

 

This document is provided as a general source of information and should not be considered personal, legal, accounting, tax or investment advice, or construed as an endorsement or recommendation of any entity or security discussed. Every effort has been made to ensure that the material contained in this document is accurate at the time of publication. Market conditions may change which may impact the information contained in this document. All charts and illustrations in this document are for illustrative purposes only. They are not intended to predict or project investment results. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors should consult their professional advisors prior to implementing any changes to their investment strategies.

 

The opinions expressed in the communication are solely those of the author(s) and are not to be used or construed as investment advice or as an endorsement or recommendation of any entity or security discussed. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Investors should consult their professional advisors prior to implementing any changes to their investment strategies.

 

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend upon or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “intend,” “plan,” “believe,” or “estimate,” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained herein are based upon what CI Investments Inc. and the portfolio manager believe to be reasonable assumptions, neither CI Investments Inc. nor the portfolio manager can assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

 

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