ETF Capital Markets Desk: ETF Liquidity – A Furniture-Shopping Story

    David Mann

    David MannHead of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments

    In previous Capital Markets Corner blogs, David Mann, head of Capital Markets, Global ETFs, has outlined some items on investors’ “wish lists” when it comes to exchange-traded funds (ETFs). In this edition, he uses a furniture-shopping analogy to further explain the concept of ETF liquidity.

    Many investors gravitate toward exchange-traded funds (ETFs) with higher average daily trading volumes because of the perception that they are more liquid, but in a prior blog, I explained why I think many investors can feel comfortable investing in newly listed ETFs with low average daily volumes.

    When reading about this subject, you may see phrases like “two sources of liquidity” or “leverage the liquidity of the underlying basket” tossed around. Although completely accurate, these phrases can be somewhat confusing if you are not familiar with ETFs or trading baskets of stocks.

    My quest for a good analogy to explain this concept in layman’s terms came to a fruitful culmination on a recent furniture shopping trip with my wife. While looking specifically for a new chair for our living room, we found ourselves in one of the store’s main showrooms, a perfectly staged area that included a sectional couch, two chairs, two lamps, a coffee table, two side tables and a rug. We started talking with the salesperson about the chairs, which she told us are one of their bestsellers. She went on to tell us that all of the furniture in this particular showroom are among their most-popular items. However, when I asked the salesperson how often they sold the entire room as shown, she stated that it was very rare—maybe a few times per year.

    It was as we were driving home, that it dawned on me that the furniture showroom was actually a decent analogy for the trading of new ETFs, and proudly shared this with my wife.

    Let’s think of the showroom, as presented, as the new ETF, and the individual pieces of furniture in it as the underlying basket of securities. If the entire showroom is a good solution for the customer, they can go ahead buy the full set in one stop by purchasing each of the individual pieces of furniture. This should be a reasonably straightforward process because each piece is individually priced and readily available. Each individual piece of furniture on its own is a well-regarded top seller, so it should be of little concern to the customer that only two other people have chosen to buy the entire showroom. Equally, the customer would have a clear understanding of the full price of the showroom set-up, by adding up the cost of each individual item.

    Back to the ETF world, then, there are two sources of liquidity: the ETF itself, and the underlying basket of the individual securities – the separate pieces of furniture in my example. If the underlying basket is liquid, it would follow that one shouldn’t have too many issues trading the ETF, even if the ETF itself only trades a few shares per day. If someone wanted to buy the entire showroom of furniture, they wouldn’t care how often other people did the same, just that it could be easily done.

    My wife, who is not in the ETF business by the way, told me that this made a ton of sense. Victory! I will leave questions like “what if one of the tables is from Japan?” for another day.

    So, for potential ETF investors, I would reiterate that high average trading volumes shouldn’t matter all that much in the decision to invest in an ETF—just as I would not let how many people have bought the entire showroom dictate my furniture-purchasing decision.

    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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    What are the Risks?

    All investments involve risks, including possible loss of principal. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect deduction of any fees or expenses. Brokerage commissions and ETF expenses will reduce returns. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value.