Getting Comfortable with ETF Liquidity

Exploring a new way to look at liquidity in exchange-traded funds.

    David Mann

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    Many people put a lot of thought into the purchase of an asset—whether it’s a car, an investment vehicle or even a more mundane item—but might not think as much about what happens when they don’t want it anymore. David Mann, our Head of Capital Markets, Global Exchange-Traded Funds, draws some parallels between buying and selling an ETF and one of those mundane items: a mattress.

    I have used restaurants and furniture stores as analogies for various elements of the ETF ecosystem and the buying and selling process. Now, I will add mattress shopping to that illustrious list!

    Last month, my wife and I went mattress shopping, as our current mattress had just hit the 10-year mark and it was time for a new one.  As I started my research, I could not believe how much has changed within the mattress industry over the past decade, particularly the growing popularity of online mattress-in-a-box options.

    Admittedly, we were hesitant to go the online route because of the inability to test the firmness of the mattress firsthand. Of course, the counter argument is how much can you really learn about the firmness of a mattress in five minutes in a showroom?

    Whether online or in the showroom, all the options seemed to have essentially the same generous return policy—some version of “try it for 90 days and if you do not like it, return it for free.”

    To me, this almost seemed too good to be true.  There were so many fantastic deals, but would the seller really buy it back from me at the exact same price I had bought it, no matter the condition?  There had to be a catch or some fine print—I was skeptical.

    Buying and Selling an ETF

    So what does this have to do with ETFs? When an investor is interested in buying large quantities of a newer ETF with lower average volume in particular, a question that’s often heard is, “Sure, you will help me get in, but will you be there when it is time to get out?” Specifically, will the ETF liquidity be there six months from now (or 90 days from now, or another time horizon) when the investor wants to sell?

    I’ve repeatedly tried to encourage investors to think about liquidity in terms of the underlying basket of securities in the ETF, not just the ETF itself. And I’ve also reminded them that there is an ecosystem of market makers and authorized market participants who stand ready to add liquidity when needed.

    But as much as we can talk about leveraging the liquidity of the underlying stocks or bonds for both buying and selling, there can be doubts until that day comes.

    The good news is we have real-world examples that demonstrate what I have been talking about actually works in practice.  Last year, one of the early investors in Franklin FTSE Japan ETF (FLJP) decided to sell $50 million of their position. The bid/ask spread at the time of the trade was four cents wide, and the trade occurred within the bid/ask spread.

    The transaction went smoothly, partly because of the aforementioned authorized participants and market makers, who helped provide liquidity for both the buy and sell side of the trades. That is their job!  They are adept at both creating shares when investors want to buy and redeeming shares when investors want to sell, even on days of heightened market volatility. Of course, we can’t guarantee every transaction will always be as smooth as this example, but it should provide some reassurance.

    But back to mattresses. I heard directly from two friends that they had no issues returning their online mattress. The liquidity was as real as promised; the online store bought back their mattress at the exact same price it was sold to them, no questions asked. In fact, because that mattress liquidity (did I really just write that?) is real, there is now a whole “mattress ecosystem” developed to help handle those used mattresses, so they do not just end up in landfills.

    Investors should have a similar level of comfort about ETF liquidity when buying—and one day selling—ETFs as well.