ETF Capital Markets Desk: Leaping over ETF AUM Hurdles

Revisiting prior ETF misconceptions with fresh eyes.

    David Mann

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

    Many investors continue to have misconceptions about exchange-traded fund (ETF) liquidity. David Mann, our head of Capital Markets, Global Exchange-Traded Funds (ETFs) revisits the topic, and offers an example of how some investors’ ownership percentage limits may be compounding the liquidity issue.

    When I launched this blog back in 2016 (has it really been almost 3 years?!), I listed out six characteristics investors ideally would like to see in an ETF: High daily trading volume (liquidity); high assets under management (AUM); tight bid/ask spread; the amount of shares available on the bid and the offer in the public market; low tracking error; and low management fee.

    Those were the characteristics that formed the foundation for my first set of posts, where I highlighted some of the biggest ETF misconceptions.

    Now that this blog is nearly three years old, I thought it would be helpful to re-read those posts to see if I would have addressed any of the ETF-related concepts differently. And of course, the answer is yes.

    I might stretch this review exercise out over several posts but for this effort, I wanted to highlight how investor ETF misconceptions are not all created equal.

    As a starting point, I might have had a misconception about the word “misconception.” When searching the internet for an official definition, I found it’s defined as a wrong or inaccurate idea or conception.

    Now, there is a huge difference between something being wrong and something being inaccurate, let alone dealing with the nuances of an actual problem.

    For example, here are two common concerns that we hear all the time (and have discussed in this blog) about newer ETFs:

    • Your ETF does not trade enough.
    • Your ETF is too small.

    The first concern is an absolute misconception: ETF volume is often incorrectly used as a liquidity gauge. Even if an ETF has a low average volume, ETF investors can purchase (or sell) large amounts because its underlying basket of stocks does have larger volumes. We see examples of this every day in funds of all sizes.

    The second concern is only a misconception if one uses AUM as a liquidity gauge. More likely, the investor cannot own more than a certain percentage of the fund, as per the rules of the Investment Company Act of 1940 or internal guidelines.

    (Quick side note…the SEC recently proposed a new rule to create a new standard set of rules related to ownership percentages for Fund of Funds Arrangements. We will discuss this proposal in a future post.)

    This ownership percentage constraint is not a misconception; it is a very real hurdle for early ETF adoption. For example, let’s say there is a fund with $10 million in assets. Four asset managers are interested, and each wants to invest $25 million but has a mandate not to exceed 25% of the AUM.

    Each of them would look at the $10 million of AUM and move on to another (and most likely larger) fund option. They would have no idea that there are others in the exact same boat. Together, they could have all invested (and the fund would be over $100 million in AUM!), but everyone is waiting for someone else to go first. Movement becomes challenging.

    There are no great solutions in this example, assuming no imminent changes to existing laws. My only suggestion to investors who pass on a fund because of ownership percentage limits: make sure the ETF issuer is aware!

    Not all investors will have the same percent ownership mandates. However, understanding and knowing the whole picture when someone assumes an ETF is “too small” could potentially help clear up the misconceptions about liquidity.

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    The 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.

    What are the Risks?

    All investments involve risks, including possible loss of principal. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.