How liquidity affects the value of your ETF

The value of an exchange traded fund hinges on the assets held in the fund. Toronto-based Canaccord Genuity portfolio manager Kim Inglis tells why you should ensure that the markets for the underlying assets of your ETF are open before buying or selling your units.

The London-based independent research and consultancy firm ETFGI confirms 2015 was another banner year for the global ETFs (exchange-traded funds) and ETPs (exchange-traded products) industry, with a 10 per cent increase in net new assets over the previous year (2015 US$372.0 billion in net new assets compared to the 2014 record of US$338.3 billion).

Global assets under management grew from US$2.784 trillion to US$2.992 trillion. The number of ETFs and ETPs increased from 5,550 to 6,146, while the number of providers grew from 239 to 276.

Consultancy Ernst & Young (E&Y) says that institutional investors outside the U.S. have been responsible for most global ETF industry growth in recent years. The trend appears to have legs.

An E&Y survey showed clear potential for a stronger institutional take-up of exchange traded funds, especially among pension funds and insurers. Active and enhanced beta funds are currently on their radar.

ETF Liquidity

E&Y notes that strong liquidity is key to attracting institutional money. This is especially important, as investors often misunderstand ETF liquidity.

Many investors, believing that a fund’s daily trading volume indicates its liquidity, think that small volumes could create difficulty entering and exiting positions. However, trading volumes have a negligible impact on ETF liquidity.

Three factors influence ETF liquidity. One is the match-up of buyers and sellers on a particular stock exchange; the second is the activity of designated brokers responsible for ensuring an orderly market; the third involves underwriters who create or redeem ETF units, thus either offsetting increased demand or tightening supply if demand falls.

ETF Composition

In fact, an ETF’s true liquidity is linked to the underlying securities, or ETF composition, not trading volume.

The BMO S&P/TSX Equal Weight Banks Index ETF (TSX─ZEB) is a good example. Its underlying holdings are the six major Canadian banks.

Although the ETF itself usually doesn’t trade many shares in a day, the bank stocks regularly do trade in the millions.

The daily trading volume of the banks is so huge that significant trade orders can be placed for the ETF without affecting its price.

A quick way to assess an ETF’s liquidity is to check the spread between buying and selling prices.

A large spread between bid (buying) and ask (selling) generally indicates that its underlying securities may be less liquid. ETFs must publish all of their holdings daily, which means investors can examine the individual securities and assess their liquidity.

Investors should be particularly mindful of this with ETFs exposed to junk bonds or emerging markets debt and bank loans.

Follow these simple ETF trading rules

Regardless of liquidity, prudent ETF investors will follow simple rules like using limit orders on ETF trades. Such rules allow investors to set limits on the prices they are willing to buy or sell an ETF, which in turn affects how much profit they collect from a trade.

Investors trading in international, commodity, or currency ETFs should make certain the underlying markets are open. If trades are made when the underlying market is closed, you may risk buying or selling at prices that are different than the ETF’s net asset value (NAV).

You should avoid trading ETFs near the open or close of a market. An ETF’s price depends on the value of its portfolio, and the underlying securities may not start trading until a few minutes after the market opens.

Specifically, investors buying ETFs at market open themselves to risk by purchasing them before prices reflect changes in the underlying securities’ prices.

Similarly, movement in the underlying portfolio can be volatile near market close, and pricing may not be accurate.

 

Investor’s Digest of Canada, MPL Communications Inc.
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