Exchange-traded funds (ETFs) are unique investment vehicles due to the fact that they allow investors to buy and sell them during regular market hours. With a simple click of the mouse, investors can add entire themes, sectors and broad exposure to their portfolios. And now with the growth of active ETFs, investors can also easily add a human touch to their investment decisions.
Except, it may not be that easy.
As a whole, ETFs thrive on liquidity. Without it, investors have the potential to skew from a fund’s actual value. Given the complexities with active ETFs and their non-index-tracking ways, liquidity of funds matters even more when delving into the active world. It’s something that investors should consider when choosing their active funds.
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ETF Liquidity 101
When you buy or sell shares of Google (GOOG) or Home Depot (HD), the entire transaction is based on supply & demand forces. If more people are willing to buy shares of GOOG or HD than there are sellers, the price goes up. If there are more sellers than buyers, the price goes down. It’s as simple as that. Bonds, real estate, gold, etc., all function in the same way.
ETFs are perhaps a weird animal when it comes to liquidity – and that’s due to their structure as well as how investors can buy/sell them.
Exchange-traded funds represent baskets of various asset classes, which come into play when we make a purchase/sale. Investors buy ETFs in the secondary market – that is, on the public exchanges from other investors. Just like a stock or bond, shares of the ETF physically change hands. But because they are designed to track an index or represent a basket of holdings, a special group of people interplay with an ETF’s buying/selling. These market makers seek to keep an ETF’s price as close as possible to its net asset value (NAV). For an ETF like the SPDR S&P 500 ETF Trust (SPY) that trades millions of shares per day, this is a relatively easy feat. The SPY share price rarely deviates its NAV, and if so, it’s only by pennies or a fraction of a cent.
However, this is not necessarily the case with smaller, less active ETFs. Bid-ask spreads – the difference between what a seller is willing to ask for an ETF and what a buyer is willing to accept for a fund – can be quite wide. Market makers can only do so much to arbitrage the bid-ask spread to get it closer to its underlying value.
But ETFs have a second source of liquidity. And that’s in the creation-redemption mechanism. ETFs are created via authorized participants that exchange cash or the physical assets for shares in the new ETF. The issues stem from how liquid the underlying asset class is. Large-cap stocks in the S&P 500 are very liquid, and buyers/sellers can always be found. The same can be said for U.S. Treasuries. Crazy exotic bank loans, commodities or real estate assets? Not so much. This underlying asset liquidity can affect the underlying ETFs liquidity and result in swings to its NAV.
Active ETF Issues
Active ETFs can potentially compound the above issues. For one thing, there are several structures that active ETFs can take. Fully transparent and semi-transparent structures allow managers to reveal their holdings daily or quarterly. But unlike a regular mutual fund, which discloses its NAV at the close, the daily tradability of ETFs can really hinder bid-ask spreads and NAVs. Market makers can be thrown for a loop when trying to gauge what an active ETF is “worth.” This is especially true when looking at semi-transparent or non-transparent ETFs that have decided to use a proxy basket for the fund’s underlying holdings. Here, an issuer uses other assets to approximate the same NAV as what’s actually in the fund. That way, no one knows what the manager is buying/selling.
Secondly, the liquidity of underlying assets comes into play. If a manager is focusing on large-cap dividend stocks, this isn’t an issue. But if they are buying less-liquid bonds or small-cap stocks, liquidity of underlying assets can affect the liquidity of the portfolio. Even worse is if a manager treads into these less-than-liquid asset classes. The sheer act of moving money into/out of these assets can push/pull prices. This, in turn, affects the liquidity of the fund.
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Pay Attention to the Total Liquidity Picture
The hallmark of ETFs is that they have dynamic pricing and all-day tradability, which makes them wonderful vehicles for investment. However, with the growth of active ETFs on the market, investors need to really pay attention to a fund’s liquidity on all levels.
Making sure that a fund can be as close to its NAV as possible and that its NAV are easily trackable is paramount. The worst-case scenario is paying a dollar for something that is worth 50 cents. This is less likely in a more liquid passive ETF. But with active ETFs and their various structures, there is a greater chance of these things happening.
All in all, active ETFs throw a wrench in the cog of ETF liquidity. Investors need to be more diligent when selecting funds to own on both the secondary and primary levels.
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