Don’t Fear the ETF Liquidity Boogeyman

Selling an exchange-traded fund (ETF) should be just as easy as buying one, irrespective of the fund’s size or volume. David Mann, Head of Global ETF Capital Markets, discusses why investors need not fear some unknown future event when making today’s investment decisions.

This blog/newsletter covers a wide array of ETF-related topics, but the subject we feel compelled to keep returning to is liquidity. This topic was discussed in my very first post on the misconceptions of using trading volume to determine ETF liquidity as well as my most recent one on better ways to keep score. In between, there have been dozens more.

I tend to focus my posts on specific elements within the ETF liquidity narrative so that investors will keep an open mind when selecting an ETF beyond those with the most volume or assets. There are numerous examples and case studies within the industry supporting this claim. However, there is one pushback we sometimes receive that can be difficult to counter: Will liquidity be there when it is time to sell?

I consider this the “Boogeyman” of ETF liquidity. “Oh sure, it is easy for me to buy this ETF today, but how do I know I’ll be able to sell my position later?” The challenge is that any example of investors selling their ETF positions with minimal market impact are from the past and do not contemplate some unknown market event at some unknown day in the future. How do you disprove an event that hasn’t even happened?

Skipping to the conclusion, selling an ETF should be just as easy as buying one, as there is nothing inherent within the ETF structure that would make selling more difficult than buying.

What if there are no buyers?!

I speculate that the Boogeyman itself—the main concern investors have—is that there will not be any buyers when they want to sell. The good news is that a proper understanding of ETF arbitrage can show why this concern is unwarranted. ETF liquidity providers do not want to take directional market bets. Their business model is to determine the “fair value” of an ETF based on the price of the underlying securities, provide a two-sided market around that value, and then hedge their risk accordingly based on the amount of buying and selling.

There is no need to worry about whether there will be any buyers on some future day because we don’t really need buyers (in the traditional sense of the word)! When investors are looking to sell, ETF market makers are simultaneously buying the ETF and selling the underlying basket (or some other highly correlated security). Likewise, the same dynamic would happen the other direction with ETF market makers selling the ETF while buying the underlying basket.

Can market uncertainty overwhelm the normal ETF arbitrage mechanism?

As always, I am going to add a caveat. ETF trading works like this almost all the time. The reason I say “almost” is that we have seen a few, rare instances over the past few years when market uncertainty overwhelms the normal ETF arbitrage mechanism. We saw that back in March of 2020 and then earlier this year with some ETFs that hold Russian securities.

In times of extreme market uncertainty, the ETF arbitrage mechanism for ALL ETFs becomes impacted, irrespective of size or volume. This was the main takeaway from the 2021 International Organization of Securities Commissions report that highlighted ETF trading behavior during March 2020. No ETFs are immune to such conditions—even billion-dollar ETFs with hundreds of millions of daily trading volume experienced excessive discounts to net asset value.

The ETF liquidity Boogeyman who thinks there might be trouble selling an ETF on some random day in the future does not exist (even if you chant its name three times!). The real concern is the occurrence of a market-wide event leading to excessive uncertainty across all ETFs.