A primer on ETF liquidity

In ‘The Ascent of Money’, Niall Ferguson outlines the birth of banking and the radical innovations of the 1700s that allowed European banks to lend more money than they physically held. Ferguson points out that this strategy has brought with it a fear of bank ‘runs’.  A bank ‘run’ occurs when a large number of bank depositors withdraw their funds at the same time. As more and more people withdraw their funds the bank must try to source sufficient physical cash.  If the bank cannot fulfil the withdrawal demands of its clients the bank may be forced to suspend withdrawals. The deposits at the bank become illiquid.

Perhaps the most famous ‘run’ on an Australian bank occurred in 1987 when John Laws told his listeners “a big building society is going to go bust.” The largest building society at the time, St George opened its doors to masses of concerned customers who feared they wouldn’t be able to withdraw their funds.  While the deposits of St George’s customers remained liquid, we now live in an age in which rumours can do more damage than fact.

As banking has evolved since the 1700s, so too has investing and illiquidity risk also impacts the managed funds you buy or the shares you own.  A ‘run’ can occur in the unlisted managed funds you own causing a fund manager to suspend withdrawals.  Panic selling can push the price of a share in your portfolio down.

It is important that you understand liquidity as it impacts how quickly you can access your money and the value of your investments. The two most important points to understand are:

1. Definition – a liquid investment can be readily acquired and converted to cash.
2. Impact on price - a liquid investment can be bought or sold at a fair value without a significant premium or discount to its fair value. 

The ASX provides a secondary market that facilitates share trading.  For larger cap shares which trade all the time, such as CBA and BHP, liquidity is high. There are always so many buyers in the market that such shares can be sold at a fair price quickly without impacting the value.  Some smaller listed companies are less liquid.  There are relatively few buyers so market forces allow them to extract an ‘illiquidity discount’ from anyone who needs to sell. Illiquidity pushes the price down.

ETFs do not have this illiquidity issue as they are listed on the ASX and operate under a set of rules prescribed by ASX known as ‘the AQUA rules’. A key feature of the AQUA rules is the requirement to have a Market Maker to ensure liquidity is maintained.

Market Makers do exactly as their name suggests. They make markets by matching buy and sell orders for investors that want to trade ETFs. This means, as an investor, you are not dependent on there being other investors wanting to sell when you want to buy or other investors wanting to buy when you want to sell. The Market Maker will do it.

The Market Maker holds an inventory of ETF shares so that they can always match the supply and demand from buyers and sellers.

Market Makers stand in the market during ASX trading hours offering to buy or sell at prices either side of the net asset value of the ETF shares. The ‘spread’, also called the “buy/sell spread” is to reward them for the service they are providing.  ETFs that have trading volumes as high as, or even higher than larger cap shares, will have a deep bench of buyers and sellers on exchange.  This means that they could trade closer to the net asset value of the ETF than the prices the market maker is offering making them more liquid.

Market Makers know the net asset value of the ETF unit because the ETF is fully transparent publishing its full holdings each day. Investors can also access this information. During ASX trading hours an ‘indicative net asset value’ or iNAV is published for Australian equity ETFs and it updates throughout the day like a share price. iNAVs allow investors to track the fair value of an ETF unit during the trading day.

Market Makers are able to keep the ETF market liquid as long as the underlying securities held by the ETF are themselves liquid. Inventory can be created or redeemed quickly because the underlying securities can be bought or sold. This is a feature of the index design used by ETFs. ETFs track indexes that filter out the smaller listed companies that do not have sufficient liquidity.

Based on the definition of liquidity being ease of trading ETFs are highly liquid.

The result is a favourable outcome for investors.  ETF investors can buy when they want and sell when they need, at a price very close to the true value of the ETF unit  avoiding premiums and discounts no matter the market conditions.

Learn more about ETFs and best practice ETF execution here.