Facts vs Fiction: Five myths of ETF liquidity and trading

The benefits of holding ETFs in investment portfolios are well known and appreciated by advisors and investors, but as capital continues to flow into ETFs in record numbers, widely held misconceptions persist as to how ETFs actually work. Is it liquidity or volume that matters?

Myth # 1 - AUM and trading volumes directly translate into ETF liquidity.

Advisors and investors often evaluate ETFs based on the volume they trade, but this is not always the best or true measure of liquidity. If an S&P-based ETF launched yesterday and no one knew about it –therefore no volume was traded – would that make it any less liquid? No. The liquidity is based on the underlying assets held within the ETF – as well as a few other factors – but not trading volume of the ETF itself. An ETF is an open-ended fund and as such, similar to a regular mutual fund, market makers will create or redeem units with the fund, based on secondary market activity.

This is why mutual funds, the older sibling of ETFs, don’t report volume. Volume does exist for mutual funds, but investors don’t tend to look for this data as it doesn’t make sense as a measure. The key is to look at the underlying assets within the ETF. Each ETF holds a basket of underlying securities, and those underlying securities define how much volume or value can trade in the ETF.

Myth #2 - It Doesn’t Matter When You Trade an ETF.

The time of day you trade an ETF can matter. Typically, investors will be able to extract better liquidity and stronger pricing when markets are open – but this is somewhat dependent on the type of ETF you hold. If you’re seeking to trade a well-diversified basket of European equities, you may be able to do so at any time of day with very little impact on your pricing. But if you were to trade a concentrated basket of something that is actively managed and that holds international components, European or other, trading when the exchange is closed will likely impact the pricing that you could achieve.

A common example of this is often seen when trading bond ETFs when the bond market is closed. If the underlying market is closed, you may have difficulty trying to fill your order. And the larger the order, the more challenging it is to fill.  So, in many cases, the time at which you trade does matter.

Myth # 3 - The Bid-Offer Spreads Are Too Large.

For this one, let’s go back to our comparison with mutual funds. ETFs have many similarities to mutual funds, but with the added benefit of being able to trade on an exchange, making them highly transparent. This transparency benefit is what reveals the bid and ask of the underlying ETF securities, unlike mutual funds, which in appearance do not have a spread that is visible to investors.

When a market maker creates a bid and offer on an exchange for an ETF, what’s really happening is simple arithmetic. A market maker takes all of the bids on the underlying basket of securities held within the ETF, and all of the offers on the basket, and reconstitutes it into a price that is posted on the exchange. What does this really mean? If you have ten securities, and all ten have a five-cent spread (meaning there’s a difference of five cents between bid and offer), that will translate back to a five-cent spread on the ETF.

So when you’re considering the spread, keep in mind that market makers are not building on top of the spread of the underlying basket, but trying to make it as tight to the NAV as possible.

Another important point to consider that relates to spread is the price point of the ETF and the spread as a percentage of the price. A $24 security with a $.06 spread is equivalent to a $12 security with a $.03 spread.

Myth #4 - ETFs Make the Underlying Market Inefficient.

Over the last five years, there have been many headlines speculating about how ETFs may perform in turbulent markets. In truth, we’ve seen ETFs perform very well through stress time and time again. Through the volatile markets caused by the COVID-19 pandemic, we saw even more investors gravitate to ETFs because they perform so well in this type of market.

Driving this popularity during volatile markets is the ability for investors to easily trade on an exchange and the fact that they’re open-ended with a market maker always there to be the other side, which means investors can buy and sell at will.

So in periods of stress, when other assets may have no bid or no offer or have a very wide spread, ETFs may actually provide a safe haven. Through the turbulent market environment of the past couple of years, ETFs have performed well and have demonstrated the ability to add liquidity to markets and help with efficiency.

Myth #5 - ETFs Are Gobbling Up Assets Like Crazy and Now They Own the Whole Market.

In terms of asset base, the ETF market is still in its infancy. But it’s a baby that’s growing quickly, with a significant year-over-year compound annual growth rate.

This is because investors are still finding ways to add ETFs into their portfolios effectively. It’s the type of investment structure that allows people to build very niche allocations to specific asset classes when they want it, with the ability to get in and get out of an asset class quickly when needed. This rapid growth is also a testament to the product’s flexibility and performance.

To the extent that ETFs “gobble up assets” as they grow, it’s not to the detriment of existing mutual fund investors and certainly not to the detriment of the market. ETFs are just a different structure than mutual funds. So if you’re worried about the size of the ETF market, why are you not worried about the size of the mutual fund market?

Dispelling the Myths

ETFs are very transparent, with the holdings and the net asset value readily available. To assess overall liquidity, just look at the ETF’s underlying securities.  And to buy and sell ETFs, avoid market orders and instead use limit orders.

Warren Steinwall is Chief Investment Operations Officer at Ninepoint Partners, an alternative investment management firm.