Exchange-traded funds (ETFs) have experienced rapid growth, and in recent years, actively managed ETF adoption has accelerated1. Amid the surge in demand, several misconceptions about actively managed ETFs have emerged. One of them is about liquidity.
As part of the active ETF myth buster series, we analyse the importance of liquidity in ETFs and how active issuers are tackling some of the challenges, so that investors can optimise opportunities across the entire ETF universe.
Why is liquidity important?
“Liquidity” defines how quickly and easily an investment can be traded without significantly affecting the price. Low liquidity can be a risk because investors may be forced to accept less favourable prices. ETF liquidity has two components – the volume of units traded on an exchange and the liquidity of the individual securities in the ETF’s portfolio.
The liquidity profile of ETFs is fundamentally different to that of stocks, where the number of shares on issue for an equity is static on a day-to-day basis. ETFs are open-ended investment vehicles that have the ability to issue or redeem units in the primary market according to investor supply and demand. As a result, the price of an ETF is determined by the value of its underlying securities and investors are able to trade large quantities of ETF units without the subsequent impact on the price of the underlying stocks.
How do active ETF tackle liquidity challenges, if any?
As mentioned above, the liquidity profile of an ETF is driven by the liquidity of the underlying securities it holds. Where ETFs hold highly liquid securities, then the ETF can be relied upon to be liquid, regardless of whether its investment objective is to track an index or provide investors with outperformance. Active ETF issuers maintain high liquidity in their ETFs by providing the market with daily portfolio disclosure and by ensuring the securities they invest in are sufficiently liquid to support the level of demand for the product.
The liquidity characteristics of a passive ETF and an active ETF can generally be assumed to be the same: in both cases, where the underlying securities are highly liquid and the ETF trades more, then the ETF has narrower spreads -- the difference between the price an investor is willing to buy the ETF (known as the bid) and the price the holder is willing to sell (called the ask) -- and high liquidity. Conversely should the underlying securities experience reduced liquidity then this reduction will be reflected in an increase in bid/ offer spread that investors pay.
Liquidity challenge arise when underlying holdings are composed of small-cap stocks or less-liquid bonds or real assets. Both index and active ETFs composed of assets such as these will face liquidity challenges, especially where investors try to trade in large sizes. Active ETF issuers have the option to steer clear of thinly traded underlying securities and liquidity screens are built into many active ETFs. Besides, active ETFs have more flexibility to rebalance which allow the issuers to exit less liquid underlying securities quicker.
Commonly, the larger and more heavily traded ETFs have tighter spreads. For active ETFs, we expect spreads to evolve over time as they become more popular. In the US, where active ETF adoption is more developed and high levels of trading take place on exchange, many active ETF spreads are on a par with passive ETFs.
Who ensures there is adequate supply?
ETF issuers engage with banks, brokers and trading firms known as Authorised Participants (AP) and market makers to provide liquidity for an ETF in the primary and secondary market. The two are often used interchangeably as several firms perform both roles in the ETF ecosystem.
To draw an analogy, the securities exchange is like a supermarket and an ETF issuer like J.P. Morgan Asset Management is like a producer. Liquidity providers buy ETF units from issuers and put them on the shelves of the supermarket where investors will come and buy/sell ETF units from these shelves. As these shelves empty, the liquidity providers will turn to the producer to restock the shelves. Likewise if the shelves get too full of units saddling the liquidity providers with too many ETFs, they will redeem the units back to the producer, and reduce the supply of units on issue.
Actioning ETF investing
While the liquidity profile of an active ETF isn’t materially different from any other ETFs, investors should conduct due diligence in much the same way as they do with a passive ETF. Investors should aim to understand the investment strategy of the ETF, as well as review the liquidity of the underlying securities in light of the spreads on offer.