By Terry Flanagan

What Lies Beneath: ETF Liquidity

As with all asset classes, possibly the single biggest determinant of whether an exchange-traded fund trade idea should move forward is liquidity.

But ETFs have a unique nuance that adds challenges, and opportunities, to the trading process — that is, as a basket of securities, the liquidity is tied to the liquidity of the underlying securities, rather than the liquidity of the “wrapper” that appears as a bid-ask spread on the screen.  

Speaking at a Friday morning ETF panel at the WBR Equities Leaders Summit, Adam Gould, Head of U.S. Equity Derivatives at Tradeweb, said there is a myth that if the spread or average daily volume isn’t good, that means it wouldn’t be good to trade the ETF.

On-screen numbers “shouldn’t be the gauge of the liquidity of an ETF,” Gould said. “Liquidity should be judged by how liquid are the underlying holdings in the index the ETF tracks, and what is the relationship with market makers.”   

From their inception 25 years ago, exchange-traded funds have gradually scaled the ladder of acceptance within capital markets and now stand at about $5 trillion globally. There is more room to run, as Gould noted that “there are still lots of sophisticated money managers that are just now thinking about ETFs.”

In addition to market makers, pillars of the ETF market are are issuers, exchanges, authorized participants, and investors, said Joe Mahoney, Institutional Sales & Trading at Jane Street.

As the latter group is the most important one, institutional trading behavior is closely watched.

The Employees Retirement System of Texas has been “dabbling” in ETFs for a long time, said Michael Clements, Chief Trader. The pension plan started in equities, and then moved into fixed income when traders learned how to use the creation/redemption process to liquidate a bond portfolio and avoid costly market impact. “If we had to sell the individual bonds, word would get out and spreads would widen,” he said.  

ERS uses ETFs mostly to equitize cash, and for asset-allocation purposes, Clements said. “As volatility in markets play out, we want to make calls quicker,” Clements said. If you’re underweight something, you can out money to work quickly” with ETFs.

Hennion & Walsh Asset Management uses all ETFs in some of its managed accounts, said Kevin Mahn, President and CIO. The firm likes ETFs for their low-cost, targeted, predictable exposure. In its trading, “we don’t care so much about the liquidity of the wrapper, we care about the liquidity of the underlying.”

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