ETF Capital Markets Desk: What Investors Look For in an ETF

We think this new blog will be a great source for investors to learn more about ETFs. It will also give timely updates on market-moving events and how they could impact the ETF space. We encourage you to ask questions or suggest topics via Twitter or LinkedIn that merit a deeper discussion. For our inaugural effort, David kicks us off with the topic of “What Investors Look For” when choosing an ETF and hones in on one item typically included on their wish-lists: high daily trading volume, or liquidity.

What attributes do investors look for when considering an ETF? When it comes to ETFs, almost all investment decisions start with a client wanting exposure to a particular asset class. From there, due diligence will be performed on the product to get a better understanding of its methodology. However, beyond understanding the construction of the portfolio, other desired ETF characteristics often enter the decision making process. These include:

• High daily trading volume (liquidity)
• High assets under management (AUM)
• Tight bid/ask spread, the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to take
• The amount of shares available on the bid and the offer in the public market
• Low tracking error, typically used for traditional index-based ETFs, representing the difference between a portfolio’s returns and its benchmark
• Low management fee

When asked which of the above list of characteristics is most important, we have found for most investors, the answer is usually “all of the above!”

Each of these aspects has particular nuances and really merits its own dedicated blog post. In subsequent blogs, I’ll go into more detail about each of these characteristics. In this first blog, we will focus on one of the misconceptions surrounding these ETF characteristics.

Let’s start with the misconceptions around high trading volume.

Many investors gravitate toward ETFs with higher average daily trading volumes because of the perception that they are more liquid. ETFs have two sources of liquidity: the ETF itself and its underlying basket of securities. Investors have generally become more comfortable in trading newly listed ETFs, even if they have lower trading volumes.

I want to address the liquidity argument when it is time to exit a position, as high liquidity tends to be most valued by investors. The liquidity of an ETF starts with the liquidity of its underlying basket. For newer products with lower average volumes, we would expect the price to purchase ETF shares to more closely reflect the price of purchasing the underlying basket.

For more liquid products, there are numerous buyers transacting with existing shareholders looking to sell without market participants necessarily needing to access the underlying basket. The perception for products with high volumes is that this liquidity provides an important benefit when it is time to exit a position quickly.

When there are more existing shareholders looking to sell than there are new investors looking to buy, market participants (ETF Authorized Participants and Market Makers) would step in as buyers. The price at which those market participants would purchase the ETF would be driven by the price at which they could sell the underlying basket, since they would most likely need to redeem shares. This dynamic only gets exacerbated when there is extreme selling pressure.

Sound familiar? That is the exact same story as what drives the price when purchasing a new ETF.

For ETFs with liquid underlying baskets (like US large-cap stocks), we would expect the price of a high average volume ETF to trade at similar levels as an ETF with low average volumes because of that high basket liquidity. For a select few liquid ETFs with slightly less liquid underlying baskets (think US small- cap stocks or high-yield bonds) there is a potential benefit of transacting within the spread of the underlying securities. However, when liquidity is needed quickly (particularly when investors look to sell) virtually all ETFs—those with both high AND low average daily volumes—trade at price levels more closely in line where market participants could sell the underlying basket.

In our next blog, I’ll discuss another item on our list of ETF characteristics—AUM—and some misconceptions therein.

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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