ETF Capital Markets Desk: The Deceiving Penny

Often, the decision to invest in one ETF vs. another providing similar exposure is based on metrics that are typically used for assessing the liquidity of single stocks. David Mann, our head of capital markets, Global Exchange-Traded Funds, says the penny spread and high trading volumes are main areas of focus—but can be misleading. He gives his two cents on the topic.

I’ve talked about liquidity a lot in this forum, because I think it’s an important topic, and one I continue to get questions about. Liquidity is one of the most popular—and misunderstood—characteristics of the ETF market.

As a refresher, although ETFs trade on an exchange like single stocks, they are different in two very important ways. The first is that ETFs have an underlying value based on the price of their basket of stocks. Because the underlying basket can typically be exchanged for the ETF at any time, the price of the ETF and the price of the basket will usually stay in-line—a process known as ETF arbitrage.

The second difference is that even if the ETF itself does not trade much during the day, the underlying basket does. This means that any analysis of an ETF based solely on its trading volume is incomplete and omits the most impactful and relevant liquidity metric.

The Impact on the Total Cost of Owning an ETF

Cost is often one of the main drivers of ETF selection. The most obvious cost is the fund’s expense ratio, which is easily accessible and straightforward when comparing ETFs. Less obvious are the costs associated with buying and selling an ETF, which should always be factored in when discussing the total cost of owning an ETF. However, when analyzing ETFs providing similar exposures, the relative importance of trading costs is minimal compared to the expense ratio.

The most widely used metric for quantifying trading cost is the bid/ask spread. There is a perception that the best possible spread is $0.01, the lowest possible spread in the United States. The implication is that an investor could buy the ETF on the offer and sell the ETF on the bid for a round-trip cost of $0.01. However, an ETF has an underlying value based on the price of its basket, and the bid/ask spread does not necessarily take this underlying price into consideration.

In reality, there are additional costs borne by ETF market participants to buy and sell the basket. For example, each of the underlying stocks has its own bid/ask spread. There are fees to exchange the stocks into ETF shares with the ETF issuer (creation costs). There may be potential hedging costs and balance-sheet costs, depending on the asset class. Any and all of the costs associated with buying and selling the basket create what are called the ETF arbitrage bands.

So, the value of the underlying basket is a more accurate gauge of cost than the bid/ask spread. For most investors who trade ETFs in large sizes, their executed traded price will be based on the price of the basket.

Ease of Exiting an ETF Position at any Time

One other misconception regarding ETF liquidity is that funds with high average daily volume (ADV) and tight bid/ask spreads make it easier to exit a position, especially in stressed markets. The perception is that the liquidity will be there when it is needed the most. As discussed, both of those liquidity metrics are misleading, as the value and liquidity of the fund’s underlying basket must be taken into account when assessing the true cost and tradability of an ETF.

The first consideration for ease in exiting a position is cost—namely, is the investor paying a fair price when selling his/her shares? The most liquid ETFs can move toward, or even past, the typical redemption bands when an ETF experiences selling pressure. This dynamic can become exacerbated in high-volume products where a majority of the liquidity is provided by high-frequency traders (HFTs). This is somewhat of a “hidden” cost to investors given the optics of the penny spread. The better way to look at the cost of exiting an ETF position is to analyze the price at which ETF market participants would sell the underlying basket.

Ultimately, a larger ETF trade will likely leverage the primary market, meaning it should trade at the basket level. When comparing two ETFs in the same asset class, as long as the underlying baskets are similar, the cost of selling an ETF will be similar as well, regardless of its size or ADV.

To think that an investor would quickly sell a large ETF position into the market during the highest level of market uncertainty is unrealistic. Instead, an investor would call one of their trusted ETF market participants to best understand all options for selling a large ETF position. If the desire is to sell a large position during a volatile market, those market participants will give guidance on the costs associated with selling the underlying basket. This explanation should reinforce the concept that any ETF, of any volume or bid/ask spread, can be sold when an investor is ready to exit a position.

When the Liquidity Misconception Isn’t Really a Misconception

As explained in previous sections, bid/ask spread can be a misleading metric for quantifying the investor’s total cost in owning an ETF. However, we recognize there are some instances when there is a benefit to having ETFs with high average volumes and tight bid/ask spreads. These include less risk in using market orders—which seek liquidity at any price—and cost savings for contrarian investors who wish to buy when most others want to sell and sell when most others want to buy.

To Sum It Up

Liquidity is often one of the most misunderstood metrics when assessing the viability of a particular ETF. Investors want liquidity but are not always sure of the best way to define it. The ETF market has tended to define liquidity using on-exchange metrics typically reserved for single stocks such as bid/ask spread and average daily volume. In reality, the liquidity of an ETF’s underlying basket is the far more accurate gauge for determining the true liquidity of the ETF. Thus, when assessing similar products with similar underlying baskets, the trading tends to be quite similar irrespective of the ETF’s size, volume, or bid/ask spread.

The key takeaways for investors are:

• The main driver of an ETF’s total cost of ownership is its management fee.
• Trading larger amounts of an ETF is not generally an issue, no matter the fund’s size or volume.
• When it is time to sell any ETF—even during times of higher market volatility—the price will be driven by the price at which the ETF market participants can sell the underlying basket.

David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

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