How Liquidity In ETF Is Different From Liquidity In Stocks
The equity markets saw a good recovery in the month of October and early November. However, many investors booked profits on their investments, thereby resulting in a decline in net inflows in equity dedicated mutual funds. For the month of October 2019, equity dedicated mutual funds saw a net inflow of Rs.6,026 crore, which is a decline of 9 per cent sequentially and is also a five month low net inflow figure. Against this backdrop, Exchange Traded Funds (ETFs) saw a significant jump in inflows for the same period. From Rs.1,521 crore of inflows in the month of September, the inflows in ETFs jumped fourfold to Rs.6,682 crore in the month of October. One of the reasons for such increase is funds was deployment from Employees’ Provident Fund Organisation (EPFO) into appointed fund houses. At present, the EPFO is only allowed to make equity investments through passively-managed ETFs.
Apart from EPFOs, passive investment has been and is being popularly followed by various investor profiles. Investing in an index ETF, whose portfolio plainly mimics the composition of an index, is an example of passive investment as the investment does not call for any research and analysis to pick stocks. Like in the case of various developed markets, India may follow the popularity of passive investments; however, there are some misconception and lack of understanding about an ETF (a popular and common vehicle of passive investing), which is deterring some investors, especially retail investors. The point of confusion is many investors believe that since individual stocks and ETFs have many similarities, they might be sharing similar liquidity traits. Therefore, liquidity of the ETF is determined in a similar manner as liquidity of stocks. Nonetheless, ETFs are fundamentally different from stocks and have robust liquidity characteristics, which is frequently misunderstood.
Liquidity in ETF
Liquidity in very basic sense is how the ease to transact in a security without having much of an impact cost and transaction cost. For instance, if you have a security bearing high liquidity, you can always sell it or purchase in quickly without incurring much of impact cost due to tight “bid-ask spreads. Lower impact cost is a priority for every investor. Better liquidity also protects a security from sharp price swings due to larger number of buyers and sellers transacting in the security.
Since both equity and ETFs are traded on a stock exchange, investors believe that the liquidity characteristics of both the securities are similar. Nonetheless, they are different. ETFs have some unique features that differentiate it from stocks when it comes to liquidity.
There are a number of myths going around regarding ETF liquidity. The most common being that lower daily volume or lower AUM gives an indication that ETF is illiquid, just like any other stock that has lower trading volume. Nonetheless, ETFs are fundamentally different from stocks.
Unlike some stocks that witness scanty volumes in the secondary market, ETFs do not suffer from this limitation. They are open ended investments such as mutual funds and can be issued or withdrawn from the secondary market according to the supply or demand situation. Therefore, if there is demand for a particular ETF, it can be created and issued. Therefore, trading volume or AUM of an ETF alone cannot determine its liquidity. It is the underlying security which forms the ETF that determines the final liquidity of an ETF. For example, IDFC Sensex ETF, which has an AUM of Rs.1 crore as at the end of October 2019 and barely trades, will not suffer from lower liquidity in case of higher demand of the ETF. This is because the underlying securities that are Sensex constituents may have enough liquidity to create the right amount of volumes for the ETF, without much of an impact cost.
The above chart is a graphical representation of the daily chart of IDFC Sensex ETF. The upper part of the graph shows the price movement while the lower part represents the volume. It is clearly evident that the ETF's price is not dependent upon the volume it draws but it is dependent on the underlying. There are few spikes representing higher volumes, but the movement in the price is not of the proportion.
This can be better understood if we examine the working of ETFs and how are they issued and withdrawn. The units of ETFs are created when professional investors—known as “Authorized Participants,” or APs—place an order directly with the ETF manager. In exchange for payment, the AP receives ETF shares, which can then be sold by the AP into the secondary market. (check the illustration).
Therefore, the ETF volume that an investor sees on the screen might not reflect the correct liquidity of the ETF. The AP can create more and more ETFs as per the demand. Moreover, if you want to invest big amount in an ETF, you can always contact the fund house to get those ETFs created.
No Dearth of Liquidity
Against the normal perception that what we see on the screen is correct projection of the ETF liquidity, the reality is investors can have access to significant hidden liquidity. If you are a large investor you can directly approach to AP or the fund company to create or redeem ETF units. Nonetheless, if you are not a big ETF investor you may not have the same luxury to approach AP or fund houses. In that case you will have to depend on secondary market liquidity. Nevertheless, there also you can find much more liquidity that you can realise. You do not see it because market maker who maintain continuous two-way ETF orders (bid and offer), are a key input to exchange order books, and they normally display only a fraction of the actual volume they are willing to trade. For example, a market maker might publish an order to buy 10 shares and an offer to sell 10 shares even though it might actually be willing to trade thousands of shares at the same price. Small quote sizes enable market makers to manage the financial risk associated with unexpected events, such as sharp market moves or technical glitches caused by any algorithmic trading.
How To Trade in ETFs
Therefore, if you want to place a large order of ETFs, it is advisable to contact the ETF issuer directly. Chances are high that he may connect the investor to liquidity providers. The liquidity provider may be an AP or an institutional investor. In a very thinly traded market, any large order will have an adverse impact on the price of the ETF. For example, if you as an investor had opted to simply enter the 10,000-share purchase as a standard market order, a market order would have been filled for 100 units at Rs.416 asking price, and then the remaining 9900 units would have automatically escalated to progressively higher prices in the order book until the order was completely filled. This may cost an investor significantly more than what he paid by directly contacting the ETF issuer. Therefore, purchasing ETFs using market orders is though common, but costly and should be avoided. Hence, in case of thinly traded ETFs, it is better to enter orders as limit orders and not as market orders. A limit order enables investors to define a specific maximum (buy limit) or minimum (sell limit) price for their trade and helps protect against the risk of the trade being fulfilled at a price that deviates significantly from NAV.
In addition to the above, timing of the day too becomes important while placing an order for an ETF. This is because ETF liquidity varies according to the liquidity of their underlying securities and most underlying securities do not have consistent liquidity. Therefore if you are a vigilant investor you can observe the trading of ETFs for few days and see when the bid-ask spreads are lowest; this will suggest the right time to invest in an ETF.
ETF indeed has been a financial innovation that has gained vast popularity among various investor classes. ETFs can be used by investors to broaden their portfolios, to better manage risk, and bring down the cost of investments. Nevertheless, to achieve this, the misconceptions surrounding ETFs should be cleared.