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IPE special report May 2018

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Observations on ETF liquidity

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The exchange-traded fund (ETF) market continues to grow rapidly in size and popularity, reaching $3trn (€2.7trn) in assets worldwide in May 20151 (figure 1). In Europe, ETF assets increased 25% during 2015, ending the year at €452bn. The market has grown by an average of 24% per year for the last three years, and in 2015 alone €72bn of new money was collected, which was 61% more than 20142

However, for some market participants this rapid growth is alarming. The collapse of several major US ETFs in August last year provided a stark demonstration of what can happen when liquidity dries up. This has in turn raised questions over the market’s ability to maintain liquidity as it expands, especially in less liquid areas such as corporate bond ETFs. In this article, we look at what makes an ETF liquid, and explore the relationship between an ETF and the underlying markets. We use research from the ETF Research Academy, an independent research organisation founded by Lyxor and Paris-Dauphine House of Finance. 

Why is liquidity important to ETF investors?
Low cost, flexible and transparent market access are the cornerstone of any good ETF offering. ETF investors can trade a practically endless selection of asset classes, geographies, themes or sectors on exchange, or over the counter, at any time during market hours, as easily as buying or selling shares. These fundamental benefits are almost taken for granted. But in reality, an ETF’s ability to deliver on all fronts is not equal, and there can be great differences between similar ETFs. 

the growth in etf assets since 2005

With total expense ratios converging, liquidity is playing an increasingly important role in fund selection as it can have a big impact on the total cost of owning a fund. It is what tells investors they can transact their buy or sell orders without significantly impacting a fund’s price. It is what creates an efficient trading environment where the cost to trade is minimal and the provision of prices is plentiful. 

It is, however, a poorly understood topic. Economists have struggled to explain why two seemingly identical funds can have marked differences in liquidity. In this article we draw on findings from the ETF Research Academy to demonstrate the source and true importance of liquidity.  

Where does an ETF’s liquidity come from?
The liquidity of an ETF is sourced from both the primary and secondary markets. In the primary market, specialised intermediaries called authorised participants (APs) transact directly with the ETF issuer to ‘create’ and ‘redeem’ ETF shares: new ETF shares are issued if demand is high or existing shares are withdrawn if supply is too great. This helps to keep an ETF’s price in line with the value of the assets by removing the influence of supply or demand on the fund.

The secondary market is where continuous trading in ETF shares occurs on exchange. Secondary market transactions can be in any number of ETF shares. The primary and secondary markets of an ETF are linked. A liquid secondary market in an ETF’s shares depends to a great extent on an efficient primary market mechanism. This is why Lyxor is constantly working on its primary market set-up to make sure it is as supportive of liquidity as possible. 

What makes an ETF liquid?
An ETF holds a portfolio (or basket) of shares, bonds or other assets, in which investors share a collective interest. It therefore seems reasonable to expect the liquidity of the ETF to reflect the liquidity of the underlying basket. Clearly, an ETF tracking an index of exotic, small-cap stocks should be less liquid than an ETF tracking an index of heavily traded large caps. But is there a one-to-one correspondence between the liquidity of the basket and that of the ETF?

In their ETF Research Academy paper Understanding ETF Liquidity, Calamia, Deville and Riva found evidence to suggest that the relationship between ETF and asset class liquidity does not provide the full picture. For the average ETF it turns out that basket liquidity is only a part of ETF liquidity. Based on a comprehensive sample of European equity ETFs over the period 2000–12, Calamia, Deville and Riva calculate that the spread of the underlying basket explains only 7% of the volatility of ETF spreads. At a minimum the liquidity of an ETF is determined by the liquidity of the underlying basket, but there are many factors than can enhance the liquidity, above that of the underlying assets (figure 2).

The empirical results shown by Calamia, Deville and Riva suggest that, while the liquidity of the underlying basket influences ETF liquidity, ETF bid-offer spreads are also systematically related to other variables such as the volatility of the index, the trading activity of the ETF, the size of the ETF, funding costs faced by the market maker and the availability of suitable inventory hedges (such as index futures). 

Why fund size matters to ETF liquidity
As we explained earlier, the secondary market bid-offer spread of an ETF is set by the interactions of the many investors, traders and arbitrageurs placing buying and selling orders. As a result of this interaction of buying and selling demand, an ETF’s secondary market bid-offer spread is often narrower than the average spread payable on the full basket of index securities. However, the extent of this difference depends on the liquidity of the ETF.

multiple factors affect etf liquidity

Calamia, Deville and Riva explored the inventory side of ETF liquidity further and found that market makers of more liquid ETFs have a number of options available to manage their inventory: notably, the secondary market in the ETF, investor inflows and outflows and the existence of hedging vehicles like futures. As such, a large part of such ETFs’ liquidity derives from certain characteristics intrinsic to these funds. 

The market makers of less liquid ETFs have fewer such options available. They are more reliant on the creation/redemption process to manage inventory and the liquidity of the ETF is therefore tied much more closely to the liquidity of the securities it holds. What investors can take from this is that the size and daily volume of an ETF matters, and highly traded ETFs can trade at much better spreads. 

Why the issuer’s set-up matters to liquidity
For the most highly traded ETFs, the virtuous cycle of liquidity can be visualised (figure 3): the tighter the bid-offer spread in an ETF, the more investor orders it is likely to attract, leading to higher turnover and more market makers, in turn helping achieve a further narrowing of spreads.

the etf liquidity cycle

An ETF provider is not a passive observer, and can incentivise market makers to support trading in its funds. Lyxor is the second most liquid ETF provider in Europe, and its ETFs are some of the most frequently traded (figure 4). This is not something that happened overnight; it took time to build the infrastructure and reach the critical size needed for true liquidity. Today Lyxor has one of the broadest networks of market makers (20) and APs (45), and some of the largest funds in Europe, which is why 20% of all Europe’s reported ETF trading was with Lyxor in 20153.

Supporting this network is an efficient creation/redemption process, with fees that reflect the actual cost of trading the underlying securities, a low minimum creation size and flexibility in terms of the assets that the AP may offer in exchange for the ETF units (for example cash, futures or an index basket). The key for any issuer is to ensure their set-up is scalable. Lyxor’s primary market turnover, for example, increased 53% with over €74bn traded in 2015. Its average daily reported turnover on exchange increased 21.5% to €571m per day.

reported turnover by provider

ETF providers can also increase the liquidity of an ETF through their choice of replication. For example, for less liquid markets such as emerging markets, Lyxor uses a synthetic ETF structure. In this example the assets owned by the ETF can be restricted to quality European assets, whereas the performance of the emerging market can be precisely replicated using a performance swap. This means the ETF holdings are more liquid than the underlying asset. 

Why is liquidity such an issue for corporate bond ETFs?
Corporate bond ETFs combine the key promise of an ETF (tradability on demand) with an underlying asset class that has traditionally been less liquid for a variety of reasons: corporate bonds are often bought and held to maturity rather than traded; they are usually traded over-the-counter (OTC) with lower levels of pre- and post-trade transparency than a centralised exchange; and corporate bond trading is highly concentrated in a relatively small number of issues. Against this backdrop ETFs have the potential to enhance both the liquidity and transparency of trading corporate bonds.

In his ETF Research Academy paper, ETFs and Corporate Bond Liquidity, Syed Galib Sultan analysed the past effect of corporate bond ETFs on the liquidity of the underlying corporate bond market. His main conclusions were that ETFs’ footprint in the corporate bond market is still relatively small (ETFs owned 1.5% of the market during the period under review) and therefore impact could be limited. The corporate bonds owned by ETFs are on average more liquid than those not owned by ETFs. The impact of ETFs on the liquidity of higher-yielding (lower credit quality) corporate bonds is also generally positive.  

Do ETFs impact the liquidity of their underlying markets? 
In his paper An Equilibrium Model for ETF Liquidity, Semyon Malamud, Professor of Finance, Ecole Polytechnique Fédérale de Lausanne and of the Swiss Finance Institute, answers the following key questions: what correlation (if any) is there between an ETF’s liquidity and wider systemic risks in markets? Can (the trading of) an ETF impact the liquidity of its underlying assets? Can an ETF create volatility in wider markets? His key conclusions are that ETFs do not automatically cause higher volatility and co-movement in stocks and that ETFs can add to trading volume and liquidity in the underlying securities. According to Malamud, the risk of the ETF market does not depend on the number of ETFs in existence or the volume of ETF assets under management. However, since ETFs can transmit demand shocks (unexpected changes in the demand for securities) to the broader markets, regulators may wish to take a deeper interest in ETF issuers’ design choices (eg, primary market costs). Malamud’s model suggests that there is an optimal model of primary market costs to reduce systemic risks. 

Why are fears of a US-style crash overblown for Europe?
On 24 August 2015 some of the major US ETFs diverged from their net asset value (NAV) by up to 50%, creating significant losses for investors. In contrast, over the same period, Lyxor observed no more than 3% of divergence between the price of its S&P 500 ETF and the intraday net asset value of the fund. The key disparity of behaviour can be attributed to differences in the markets. In the US, ETFs are considered independent vehicles with their own source of liquidity, separate to that of the underlying assets, whereas in Europe ETFs are considered an extension of their underlying assets. As such, European exchanges tend to enforce stricter rules to keep ETF prices in line with moves in their underlying assets. 

The ETF Research Academy
A new framework for the ETF industry The ETF Research Academy was created in 2014 in the newly founded Paris-Dauphine House of Finance, with the support of Lyxor Asset Management. The academy’s aim is to promote high-quality academic research on ETFs and strong links between academia and the ETF industry. The academy’s objective is also to focus on key areas of interest for investors in ETFs and to develop an analytical framework covering ETFs and indexing. 

François Millet, Head of Product Line Management, ETF & Indexing, Lyxor International Asset Management 

1 Source: ETFGI, December 2015. 
2 Source: Lyxor International Asset Management. Data as at December 2015.
3 Source: Lyxor International Asset Management. Data observed between January 2015 and December 2015.

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