ETFs: sorting fact from fiction (Part 1)

There’s no doubt exchange traded funds (ETFs) are shaking up the wealth industry across the world, including Australia, and, as such have naturally attracted their fair share of friends and detractors in the process.  As a relatively new product in Australia, it’s also understandable that many investors are still learning to sort through the many claims and counter-claims made about ETF investing.  To help in this regard, I have taken the time to outline my response to some of the most common ETF questions and concerns that have been raised with me by investors over the past few years. The first part of the post deals with ETF liquidity. I’ll follow up next week with Part 2 which deals with the claims that ETFs are complex and risky and that they may be responsible for causing a bubble in sharemarkets (spoiler alert: they aren’t and they aren’t)!

Fiction: ETFs are illiquid

Questions about ETF liquidity are probably the most common questions I have received over the years.  This concern principally stems from the fact that the amount of ETF units showing for bid and offer on online share trading screens at any point in time may not seem particularly large and some ETFs don’t seem to trade that often (for example when looking at daily value of units traded on share tables and in the newspaper).

The misconception arises, however, because these widely viewed measures of “on-screen” liquidity – which measure the ready availability of buyers and sellers in the market – are really only relevant in the case of securities with fixed supply, such as listed investment companies and individual stocks.  In the case of ETFs, these measures are less relevant as they don’t capture the far deeper levels of “off-screen” liquidity available – as ETF market makers effectively stand ready to buy or sell much larger quantities (i.e. adjust supply) at prices very close to net-asset value (NAV).

The detailed mechanics behind this process are more fully explained here and here  but suffice to say the main take-away for investors is that the liquidity of an ETF goes significantly beyond ‘on-screen’ liquidity and should be at least as much as the liquidity available in the underlying holdings (so, for example, in our Nasdaq 100 ETF, the underlying liquidity of the shares making up the Nasdsaq 100 Index). As such, it should usually be possible to buy and sell sufficient quantities of an ETF at prices quite close to NAV through the trading day – irrespective of the amount currently on offer or the amount traded in recent days.  A tell-tale sign of good underlying liquidity for an ETF are quite tight bid-offer spreads and prices trading reasonably close to NAV over time.

Of course, it is true that a growing band of relatively niche ETFs are springing up across global markets, and the underlying liquidity of the assets they hold may not be very high (e.g. small gold exploration stocks).  But this is a challenge specific to these particular ETFs, rather than ETFs in general. As always, it’s a case of buyer beware.

Fiction: ETF liquidity will be withdrawn in times of crisis

A related concern is that while market makers may be ready to buy or sell ETFs during normal trading times, they may retreat to the sidelines in times of crisis.  In other words, the concern from investors is that, just when they need it most, liquidity could simply evaporate. The truth is that there is no reason to think that liquidity of ETFs during such crises should be any worse than liquidity in other investments (such as shares and managed funds).

The first point to note is that shares and managed funds may behave abnormally in abnormal times – it is unfair to single out ETFs.  A lack of buyers in times of crisis, for example, can cause the price of individual shares to fall- until such time as reluctant buyers are drawn into the market. Unlisted managed funds may also experience a surge in investor redemptions – which can and has caused many funds in the past to sell their holdings at bargain-basement prices or even halt redemptions for unitholders altogether.

In the case of ETFs, there is no reason to suggest that, during a crisis, the ETF market-makers would “disappear from the screens”. It is important to note that these players are contractually appointed by the ETF issuer to provide market-maker services and have no motivation to “flee the scene” if the going gets tough. This is because market-makers are compensated by the volume of trading they do, and are typically indifferent to market movements. It is important to understand that market-makers benefit from increased levels of trading activity. As it is typically the case that trading activity rises during crisis events, market makers are, in many ways, more incentivised than ever to remain on the screen during these times.

Of course, if the market price of underlying securities drops during a market crisis, this will be reflected in an ETF’s NAV – but this is the nature of the ETF’s exposure to the market, not the ETF vehicle per se.