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Measuring an ETP’s true liquidity

  • EDUCATION
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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Education Series: Single-Stock ETPs

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Category: EDUCATION

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The value of an investment in ETPs may go down as well as up and past performance is not a reliable indicator of future performance. Trading in ETPs may not be suitable for all types of investors as they carry a high degree of risk. You may lose all of your initial investment. Only speculate with money you can afford to lose. Changes in exchange rates may also cause your investment to go up or down in value. Tax laws may be subject to change. Please ensure that you fully understand the risks involved. If in any doubt, please seek independent financial advice. Investors should refer to the section entitled “Risk Factors” in the relevant prospectus for further details of these and other risks associated with an investment in the securities offered by the Issuer. 

This website has been approved as a financial promotion, for the purposes of section 21 of the Financial Services Market Act 2000 (FSMA), by Resolution Compliance Limited which is authorised and regulated by the Financial Conduct Authority (FRN:574048).

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Interactive Brokers is not affiliated with and does not endorse or recommend any referrer partners, introducing brokers or financial advisors including Leverage Shares PLC. Interactive Brokers (U.K.) Limited, and its U.S. registered affiliate, Interactive Brokers LLC, provide execution and clearing services to customers of Leverage Shares PLC. None of the information contained herein constitutes a recommendation, offer, or solicitation of an offer by Interactive Brokers to buy, sell or hold any security, financial product or instrument or to engage in any specific investment strategy. Interactive Brokers makes no representation, and assumes no liability to the accuracy or completeness of the information provided on this website.

For more information regarding Interactive Brokers, please visit www.interactivebrokers.co.uk.

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Risk Warnings

The value of an investment in ETPs may go down as well as up and past performance is not a reliable indicator of future performance. Trading in ETPs may not be suitable for all types of investor as they carry a high degree of risk. You may lose all of your initial investment. Only speculate with money you can afford to lose. Changes in exchange rates may also cause your investment to go up or down in value. Tax laws may be subject to change. Please ensure that you fully understand the risks involved. If in any doubt, please seek independent financial advice. Investors should refer to the section entitled “Risk Factors” in the relevant prospectus for further details of these and other risks associated with an investment in the securities offered by the Issuer.

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