Strong growth in ETFs and more want to use them
Liquidity the key issue to understanding how they work.
As the demand for exchange-traded funds (ETFs) continues to grow strongly, so does the hunger for more information about how the products function. A recent research report from Investment Trends into the habits of Australian investors suggests that about 192,000 plan to make an ETF investment in the next 12 months.
That follows a 48 per cent growth in assets invested in ETFs in 2014, according to an ASX market report.
The strong growth in ETFs is not unexpected given their decade-long growth trend in the US and European markets. But what is encouraging is the desire among investors to learn more about the products and the way they work.
At a basic level, an ETF is a simple index fund. Its job is to track a target index, be it broad market indices such as the S&P/ASX 300 or MSCI World ex-Australia, or more targeted segments of the market such as high-dividend or small-cap shares, and so on.
Most ETFs can be thought of in the same way as an index managed fund that is listed for trading on ASX. It is the investor's choice whether to buy through the ASX fund or opt for the unlisted fund through a financial adviser.
While investors, and advisers, are becoming increasingly familiar with the benefits of ETFs, there are ongoing questions and misconceptions about the true liquidity of those listed on ASX.
To understand ETF liquidity, it helps to start with a simple comparison between ETFs and individual stocks. A company's stock price is based on market supply and demand (is there a buyer and seller for the stock?) Or is there any market or company news that could drive the stock price higher or lower throughout the day?
An ETF is a portfolio made up of multiple securities. While market supply and demand could affect its price in certain circumstances, a more significant factor is the value of the ETF's underlying portfolio of securities.
The relationship between average daily trading volume (ADV) and liquidity is also different for ETFs and securities. A single security's liquidity is based on its trading activity on the sharemarket, which reflects investor demand for a fixed supply of shares. In this case, a measure of trading activity provides a good indication of a specific company's security liquidity.
With ETFs, ADV provides only a partial indication of liquidity because, unlike single stocks, the supply of ETFs is open-ended. New ETF units can be created and existing units redeemed based on investor demand.
The creation and redemption process supports ETF liquidity by regulating the supply of ETF units in the secondary market as needed to meet investor demand. It also allows investors to execute large buy and sell orders for lower-volume ETFs, with little or no market impact.
The sources of liquidity
Visible liquidity on the exchange: The most visible source of ETF liquidity is the trading activity of buyers and sellers in the secondary market that takes place on an exchange. This liquidity is affected by the number of firms trading each ETF, the number of orders from other investors and the investment environment on that day. ADV is a measure of this trading activity but does not represent an ETF's total liquidity.
The natural liquidity of ETFs trading in the secondary market is enhanced by exchange-registered traders called market makers. They help maintain a fair and orderly market by selling ETF units to potential buyers and by buying ETF units from potential sellers. In the absence of another buyer or seller, a market maker can often match the other side of a pending order.
"Hidden" liquidity on the exchange: Not all of an ETF's liquidity in the secondary market is readily visible. For most investors, on-screen view is probably limited to what's available through public financial websites. This means you will have access to an ETF's highest bid price and lower ask price, but you will not be able to see all the quotes. These quotes are another source of ETF liquidity because they represent additional prices at which ETF units can be traded.
Liquidity from underlying securities: Although trading activity and market depth on the sharemarket contribute to ETF liquidity, most of an ETF's liquidity comes from its underlying securities. ETFs access this liquidity with the help of large institutions, which act as Authorised Participants (APs) or market makers to create and redeem large blocks of ETF units directly from the ETF manager. This activity takes place in the primary market, as shown in the graphic below:
In action, this process allows for an investor to purchase an amount of units in a given ETF that exceeds the ADV.
The motivation for an AP to play such an active role in ETF liquidity is the remuneration from their own market activities, and it is worth noting they operate at arms-length from ETF issuers.
Market makers in Australia are offered a financial incentive by ASX to maintain spreads and liquidity on-market; market makers are active market participants and earn revenue through the bid/ask spread and volumes that they trade. APs earn revenue by acquiring ETFs in the primary market at the ETF's net asset value (NAV) and then selling in the secondary market at a margin above the NAV.
Similarly, they can acquire ETF securities in the secondary market below the NAV and redeem in the primary market. Competition between the APs quoting each ETF security helps to ensure that bid/ask quotes for the ETF securities are consistent with the NAV. APs that quote wide spreads will be undercut by other APs and as a result will not have competitive trades available for the market.
This creation and redemption process allows ETFs to get most of their liquidity from their underlying securities.
When the underlying securities are difficult to trade, the market maker's costs may increase; resulting in wider bid/ask spreads than usual or compared with ETFs in other asset classes. As long as a dealer can efficiently trade the securities in the ETF basket, it can adjust the supply of ETF units in the secondary market as needed to meet investor demand.
As with any investment, every ETF has a unique liquidity profile that is based on how easy it is to trade the ETF's underlying securities, the costs associated with the creation and redemption process, and a range of other considerations specific to each fund that extend well beyond the ADV.
About the author
Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia.
If you have overlooked ETFs because you do not understand them, or because they did not offer you the exposure you were looking for at the time, now might be a good time to review the ASX online course on ETFs. The course is free and no registration is required. The material is divided into topics so you can skip those you are not interested in and focus on those you are. There are many graphics and activities to help you reinforce what you have learned.
You may notice that ASX is covering more product types in its ETF course. In addition to Exchange Traded Commodities, we now provide you with a good introduction to Fixed Interest ETFs as well.