Measuring an ETP’s true liquidity

It is no secret that ETPs continue their dominant growth in popularity, as global ETP/ETF AUM reached a new high of $6 trillion in 2019. The combination of enhanced transparency, lower costs and increased liquidity has made them the preferred alternative to traditional mutual funds. Despite the increased awareness of these products, some general misconceptions still persist – especially regarding the topic of liquidity.

When most investors check data on liquidity, the steps are relatively straightforward. Check the bid price, the ask price, and the volume being traded. The smaller the spread and the higher the volume, the more liquid the product is. Simple, right? Yes – and no. In the case of a normal stock, the aforementioned is true. However, when considering the same for exchange-traded products (which include ETFs), the indicator has another layer to it.

Prior to exploring the depths of ETP liquidity, let us review a few key terms distinctive to these products:

    •     Authorized participant (AP) – Usually a large financial institution, like an investment bank that

interacts directly with the ETP issuer.

    •     Market maker (MM) – Financial institution that has a contract with the exchange to provide

constant bid/offer spreads throughout the day. In many cases, the AP is also the MM.

Unlike typical mutual funds and closed-end funds, ETPs have an inherent redemption mechanism, which helps keep the market price in line with its NAV. Like normal stocks, as the ETP price fluctuates throughout the trading day, the AP can step in and do one of the following:

    a.     If the market price > NAV, the AP can buy the constituent stocks and simultaneously

exchange them for ETP shares, which can then be sold to investors.

    b.     In the opposite scenario, where NAV > market price, the AP can purchase ETP securities and

exchange them for the constituent securities, which it will then sell on the market to make a riskless profit.

This arbitrage mechanism is available only to authorized participants who deal directly with the ETP issuer in the primary market. As retail investors only have access to the secondary market, they can then purchase and sell the ETP shares on a regulated stock exchange (like the London Stock Exchange or Euronext Amsterdam) through a broker as they would with any other stock. As ETPs are open-ended, meaning new units can be created/redeemed as needed, actual liquidity is more dependent on the underlying stock. For example, if an investor wanted to buy additional ETP securities on an exchange, the AP makes a transaction with the ETP issuer to create new units as needed.
Conclusion

Low volume on the actual ETP security does not indicate a lack of liquidity, and the investor is better served by checking the average daily volume of the stock(s) that constitute the ETP. As most of the underlying assets tracked by ETPs are highly liquid, most can draw tens of millions without having a negative impact on the liquidity of the underlying assets. This is essentially the case even if the ETP has a relatively small amount of assets under management.

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