The third golden rule of ETF investing

Joni Mitchell sang, “you don't know what you've got 'til it’s gone”. Apparently someone had “paved paradise and put up a parking lot”.

You could sing the same line about liquidity. It is something investors do not appreciate it until it is gone. Over the past few weeks, in a few small pockets, liquidity has been under pressure and this has highlighted the importance of good ETF trading practices.

Liquidity was the subject of a previous Vector Insights – A primer on ETF liquidity

In that Vector Insights we highlighted that liquidity impacts investments in two ways:

1. How quickly you can access your money; and
2. The value of your investment.

A very liquid investment can be readily converted to cash, and can also be bought/sold at a fair value without a significant premium/discount to its fair value.

But what happens in a period, like now, when the market is falling? Investors who need to convert their investment to cash quickly, to meet short term obligations, incur what is called a ‘liquidity premium’. The premium is the cost you pay to redeem in a falling market.

In periods of market volatility, trade execution through a limit order can provide you with a way to limit your ‘liquidity premium’.

Trading ETFs

Remember, there are two ways to input your buy or sell ETF order:

Limit Order - this allows you to set your ‘bid’ or ‘ask’ price. This means you will not pay (or receive) any more or less than your limit price. This type of order protects your price but does not guarantee your trade.

Market Order - this means you will buy or sell at potentially any available market price. This type of order guarantees your trade, but leaves you exposed on price.

We previously discussed these here - Two golden rules when investing in ETFs

Understanding how to trade is important now, more than ever, because markets are moving so quickly. One of the many features of ETFs is their liquidity.

Two of the ways ETFs provide investors liquidity are:

1) via trading on ASX; and

2) via screening of the underlying holdings.

The secondary market: the ASX

Just like shares in companies, units in ETFs are listed and traded on an exchange. In Australia ETFs operate under a set of rules prescribed by ASX known as ‘the AQUA rules’. Think ‘liquid’. A key feature of the AQUA rules is the requirement to have a Market Maker to facilitate maintaining liquidity on ASX throughout the trading day.

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. Market Makers stand in the market during ASX trading hours offering to buy or sell at prices either side of what they consider to be the current value of the ETF shares.

The Market Maker holds an inventory of ETF units so that they can always match the demand from buyers and they sit ready to acquire more units from sellers. Market Markers charge a ‘spread’, also called the ‘buy/sell spread’ to reward them for the service they are providing and to reflect the costs and risks associated with buying and selling the underlying assets.

In the current market environment, investors should pay particular attention to the ‘buy/sell spread’ on any investment, because these have been changing throughout the trading day due to changes in the liquidity of the underlying holdings.

The liquidity of the underlying holdings

Another key feature of the AQUA rules is the requirement for issuers to satisfy ASX that the underlying holdings in an ETF have robust pricing mechanisms which enable prices to be immediately ascertained. This is intended to ensure that Market Makers are able to keep the ETF market liquid as long as the underlying securities held by the ETF are themselves liquid.

This is a feature of the index design used by ETFs. For example, equity ETFs should track indices that filter out illiquid micro-caps.

In typical market conditions Market Makers are able to price the underlying securities easily so they only charge a small spread representing their estimated cost of selling the underlying holdings. In times of market turmoil it can be hard for Market Makers to constantly price the underlying securities therefore they widen their spreads. This has been prevalent in fixed income and credit ETFs.

Differences in liquidity between equities and fixed income securities

Equities

Liquidity for equities has been largely unaffected during the recent market turmoil. For large-cap shares which trade all the time, liquidity is high. There are always so many buyers in the market that such shares can be bought and sold quickly.

There have however been isolated incidents in international equities over the past few weeks in which the Market Maker has not been able to accurately assess the value of the ETF’s underlying holdings. For example in the US, the S&P 500 stock-index futures’ circuit breaker was triggered when it dropped by more than 5%. For a short time the Market Maker may have widened the spread on ETFs with US equity exposure because they couldn’t properly price the underlying holdings of the ETF.

This highlights the importance of limit orders over market orders. Those placing market orders may have accidently incurred the higher spread. By using limit orders you can limit the chance of incurring a higher spread, as these pauses in equity trading are generally short lived, as too are the wide spreads.

Fixed income and credit

Fixed income and credit investments are not traded on an exchange, rather, they are traded over-the-counter (OTC) between buyers and sellers. Banks and brokers, who facilitate bond trading between institutions, generally carry a book of bonds on their balance sheet to assist with trading and making a liquid market. This works well in normal market conditions.

There is however a limit to how much they can hold on their balance sheets. In the current market environment where there are more sellers than buyers, selling bonds at fair prices become difficult. This causes a ‘liquidity crunch’. It is not uncommon for ETFs with these type of exposures to experience wider spreads. As liquidity in the underlying bond market dries up, Market Makers will widen spreads to reflect the prices they believe they can trade the bonds for. This is then reflected as a discount to Net Asset Value (NAV).

Again, trade execution through a limit order provides you with a way to avoid higher spreads if they widen beyond your price. Remember too, these are extreme times, and, all things being equal, we expect spreads to normalise over time.

Take away

It’s important to remember, while a limit order limits the price, it does not guarantee the trade. Conversely, while a market order ensures the trade, it does not limit the price.

We’re here to help

One of the advantages of ETFs is that they are traded throughout the trading day on ASX. Throughout this recent volatility we are not aware of an ETF on ASX that has been forced to stop trading, however effective trade execution is an important part of fully realising the benefits of ETFs for investors.

To learn more about ETF liquidity or for guidance on best practice ETF execution please feel free to call us on 02 8038 3300 or email us at info@vaneck.com.au.