ETF Liquidity not as simple as it appears
A few weeks ago, I was having a conversation with an advisor about ETFs. We were talking about one in particular that I thought was interesting, the PowerShares S&P/TSX Composite Low Volatility Index ETF (TSX: TLV). While he agreed that the idea of low volatility investing was interesting, he said that he was a bit wary about using this ETF because the average daily trading volume was only a couple of thousand shares. He was worried that this low level of volume may affect his ability to get clients in and out of it if easily.
His viewpoint certainly made sense. After all, with equities, the ability to get in and out of a position easily is a function of the daily trading volume. If there is a lot of volume, it is quite easy to get in and out. However, with little trading volume, it becomes much a much more difficult proposition to get your orders filled. Intuitively, this same logic should also apply to ETFs.
However, after doing a little bit of research on the topic, it turns out that is not quite the case. Speaking with Michael Cooke, the head of distribution for PowerShares Canada, he said, “The daily trading volume of an ETF is really only one aspect of its true liquidity. To fully understand the liquidity, you have to look at the mechanics of the ETF creation and redemption process. Market makers are pricing the underlying basket of securities of each ETF in real time and it is their job to issue or redeem ETF shares as necessary to keep the market in balance. So in reality, the true liquidity of an ETF is the liquidity of the underlying securities.”
In other words, if an ETF trades in larger, more liquid securities, market makers should have very little difficulty filling any trade orders that may be placed. Mr. Cooke also pointed out that on these types of ETFs, the bid/ask spread is often quite narrow. However, for ETFs that invest in illiquid securities, like some of the small cap focused or sector specific ETFs, liquidity is more of a concern. Mr. Cooke said that with these ETFs you will quite often see bid/ask spreads that are much wider than with other ETFs, since market makers may keep the spreads wider as a way to hedge the liquidity risk of the underlying securities.
Looking at the bid/ask spreads on the iShares S&P/TSX 60 Index Fund (TSX: XIU), the most actively traded ETF in the country, we find that the spread is typically only a penny or two. However, with a highly specialized ETF, for example the iShares S&P Global Water Index Fund (TSX: CWW), the bid ask spread was more than $0.20 on March 27.
This wider spread is not unexpected for two reasons. First, its average daily trading volume is only 2,500 shares, indicating that there is not a lot of investor interest in the product. Second, and perhaps most importantly, it invests in a very narrow band of securities that are involved in water related businesses. It isn’t exactly filled with household names and none of the stocks seem to have a significantly high trading volume.
There are a number of ways that you can protect yourself while trading relatively illiquid ETFs. The first is to use limit orders. “Market making is very strong in Canada” says Mr. Cooke, which means that it is likely that your order will be filled if you set a limit price somewhere between the bid and the ask. This will help you to get much better trade execution than by simply using market orders.
Other strategies that may help to help you get better execution include paying attention to the time of day that you place your order. For example, at the market open, there may be stocks that are not open for trading because of news, a corporate action or some other delay. When this happens, it is likely that you will see a widening in bid/ask spreads because of the uncertainty caused by this delayed opening.
Another thing you will want to watch is ETFs that trade in overseas markets or in fixed income instruments. The Canadian stock markets where ETFs trade are open between 9:30 a.m. and 4:00 p.m. Many overseas markets are closed when Canadian markets are open, and trading in the bond market stops at 2:00 p.m. If you are trading in ETFs in these markets, you may see wider bid/ask spreads because of the higher uncertainty resulting from the markets where the underlying securities are traded being closed.
Bottom Line: The daily trading volume of an ETF is only one aspect of its true liquidity. To get the full liquidity picture of an ETF, you must consider the liquidity of the underlying investments, which is a more accurate determinant of its liquidity. By using limit orders, you can protect against the potential of wide bid ask spreads sometimes found with the more illiquid ETFs.