As with a stock, an investor can find a price for an exchange-traded fund on the screen and click to buy or sell.

The similarities end there. Whereas a stock price represents a direct ownership unit of an enterprise, an ETF price is an amalgamation that reflects the value of the underlying securities. And whereas a stock can be transacted only via an all-in price, an ETF can be bought (sold) by essentially building from the ground up (deconstructing from the top down) via its component securities.

“It is incredibly important for investors to understand that an ETF’s liquidity is a combination of two factors: its on-screen liquidity and the liquidity of its underlying securities,” said John Hollyer, principal and head of Vanguard Risk Management.

“The on-screen liquidity of an ETF is typically characterized by its average daily volume,” Hollyer told Markets Media. “ETFs with substantial trading volume may appear to offer superior liquidity, however, an ETF’s ADV is not the only gauge of liquidity. An ETF’s bid-ask spread may provide a better indication of liquidity because it incorporates the liquidity of an ETF’s underlying securities and the associated costs for (Authorized Participants) to engage in the creation/redemption process.”

That process is the behind-the-scenes hammering and drilling, stripping and unscrewing that makes the ETF market unique. A rough stock-market approximation could be a corporate spin-off, in which a company divests a business and shareholders receives separate shares — however, such macro transactions occur very infrequently and generally not at the request of shareholders, whereas in the ETF market, micro-level creations and redemptions happen on a continuous basis through the trading day.

An institutional investor who wishes to buy or sell a large block of equity can perhaps go to a so-called dark pool to transact, in order to avoid the adverse market impact that would come with just dropping the order on a ‘lit’ exchange. With ETFs, large blocks are best transacted via customization.

“Market makers have the ability to create and redeem ETF units based upon client demand,” Hollyer continued. “Even large trades in an ETF with a low ADV can avoid having significant market impact costs, provided that ETF invests in a highly liquid market. An investor can access this true ETF liquidity by leveraging the experience and expertise of their block trading desk.”

Most any retail or institutional investor can trade an ultra-liquid ETF, such as the Emerging Markets ETF (VWO) or the SPDR Gold Trust (GLD), easily and efficiently, just as one can buy or sell Google, Apple or General Motors shares with little friction. But below the top liquidity tier in both the ETF market and the stock market, end users’ mileage may vary.

The Tennessee Consolidated Retirement System has used ETFs for about eight years. The $43 billion pension plan has ratcheted up its usage from smaller, shorter-term and tactical deployments initially, to longer-term allocations.

TCRS’ invests in emerging-market equity ETFs, including some that are somewhat obscure and off the beaten path of the deepest liquidity channels, according to Michael Brakebill, chief investment officer at TCRS.

Brakebill described his view on ETF liquidity as “not pollyannaish,” but he noted that TCRS does not trade liquidity-challenged fixed-income ETFs, and overall the organization can do what it needs to do in the ETF market.

“We look at bid-asks, we look at volumes, and we look at everything else about the issues themselves,” Brakebill told Markets Media. “Most or all of the ones we have can be created or redeemed essentially, so we can get exposure to the underlying liquidity.”

Added Brakebill, “we see our ETFs as fairly liquid — with the equity ETFs, we can get down to the underlying stocks if we have to.”

Large institutional investors typically use ETFs in some fashion; a challenge for the industry is improving the user experience and then growing the ETF pie. “At this point we don’t even ask our institutional customers ‘do you use ETFs?’,” said Michael Baradas, product manager for cross-asset strategies and ETF solutions at Bloomberg Tradebook. “Now we ask them, ‘what do you use them for, how do you use them, and how do you access liquidity?”

“ETFs trade on stock exchanges electronically and transparently, just like stocks do,” Baradas said. “But in terms of how liquidity is created in ETFs, it’s very different.”

Featured image via tiero/Dollar Photo Club

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