ETF Strategy: how to spot liquidity traps

One of the benefits of exchange traded funds (ETFs) is the intra-day liquidity they provide, but investors should be aware how liquidity levels can vary and the ways in which this can affect the cost of trading.

An ETF has two main sources of liquidity based on the stocks underlying the ETF and the amount at which the ETF is traded. Liquidity can be affected, for example, by market conditions, such as if the underlying market is closed or at times of investor uncertainty.

‘If liquidity is poor, spreads will be wide,’ said Christopher Aldous (pictured) chief executive at Evercore Pan-Asset Capital Management. ‘It also depends on your view on the underlying asset. ETFs on the US market, for example, are pretty liquid.’

He said there is an established futures market covering the US, so it is easier to gauge where the markets will be and price from this. Conversely, he said that emerging markets do not have such a developed futures market, meaning it is more a case of taking a view, which could lead to these ETFs having wider spreads.

Don’t rely on screen trading volumes

Although ETFs trade like stocks on an exchange, investors should not just rely on looking at screen trading volumes to determine the liquidity of an ETF.

While one level of liquidity does stem from the volumes of ETFs traded, the other arguably more prominent source is derived from the liquidity of the underlying constituents of the index.

Another reason why investors should not rely on trading volumes printed on-screen is caused by the paradoxical nature of the European market, whereby the majority of ETF trading takes place off-exchange, or over-the-counter (OTC). 

This is compounded by the fact that there are no regulatory requirements to report OTC trades, which limits the available data on transparency and pricing.

The second instalment of the Markets in Financial Instruments Directive (Mifid) is set to include OTC reporting requirements for ETFs. Many market commentators are also expecting an EU directive that will result in all trading activity for an ETF taking place under one ticker symbol, as it does in the US.

Creation/redemption process

Taking liquidity at the level of the underlying securities, the creation/redemption process ensures the price of the ETF shares stay linked to the price of the underlying holdings.

BlackRock explained the portfolio manager of an ETF provides a description of a basket of securities that they are willing to take into the fund at the end of the day, in exchange for providing new shares within the ETF. The ETF manager then appoints authorised participants (APs) for this process. These APs are broker-dealers who are able to take or deliver the basket of securities in exchange for the ETF shares.

BlackRock took the iShares EuroStoxx 50 trading on 15 July last year as an example to show how the creation redemption process affects liquidity.

The firm said between 8:30am and 8:45am the basket of stocks in the EuroStoxx 50 could have been bought at a price of £24.20 or better, or sold at £24.03. As these stocks are large and liquid, the basket reveals a tight spread of around 14 basis points through the day.

Rather than buy the basket of underlying stocks, investors can easily buy the ETF tracking the same stocks. The price of this ETF stayed within the bid/ask spread of the basket itself, showing that the ETF is very liquid.

However, if for any reason the price of the ETF moves outside the bid/ask range of the underlying securities, then an arbitrage opportunity crops up.

This arbitrage activity ensures the ETF can only trade outside the bid/ask band of the underlying securities for a limited period of time and to a small extent, otherwise other market players can come in and profit from the difference. For investors, this arbitrage mechanism is positive because it helps the ETF trade within the tight bid/ask band of the underlying securities.