ETFs: Underlying Liquidity vs. Secondary Market Liquidity Explained
The content of this post is relevant to institutional investors interested in trading ETFs in significant size. Individual investors do not always have access to liquidity providers to trade ETFs as referenced below.
We have heard it over and over: Exchange-traded funds (ETFs) are wrappers, and the true liquidity of an ETF is derived from its underlying constituents.1 While that statement is true, it does not completely explain different types of liquidity that can exist in an ETF. ETFs trade on the secondary market (stock exchange) but are created and redeemed on the primary market (issuance). There is still a bit of confusion over the difference between these two markets, how they interact with each other and how investors can access liquidity via either market.
Different types of ETFs can serve different purposes as exchange-traded vehicles, depending on the exposure they provide. Some ETFs are used primarily for hedging and intraday portfolio trading. These ETFs typically track major world benchmark indexes, and they trade millions of shares per day. Other ETFs are structured more as investment vehicles and don’t typically have very high average daily trading volumes. Investors come into the products, hold their positions and eventually unwind the investment months or years down the road. While all ETFs can be held for prolonged periods or intraday, some ETFs experience more secondary market trading than others. At WisdomTree, we structure all our ETFs with liquidity screens to help provide sufficient implied liquidity (underlying liquidity), so even if the ETF has a low average daily volume in ETF terms, that does not mean the ETF is illiquid.
A recent comparison between the WisdomTree India Earnings ETF (EPI) and the WisdomTree LargeCap Dividend ETF (DLN) helps illustrate the difference between primary market and secondary market liquidity. As the industry’s first India ETF (launched in February 2008), EPI has become a popular way to gain intraday tactical exposure to India equities. For example, during the week of May 20, 2013, to May 24, 2013, EPI traded roughly $325 million of dollar trading volume on the secondary market. Yet during that week, EPI had no creation/redemption activity. There was $325 million of dollar volume traded and there were no inflows or outflows that week in EPI. That is secondary market liquidity. Investors were able to easily buy or sell EPI on the secondary market, as buy and sell orders were matched up by the broker-dealers. While new shares can be created on the primary market if demand warrants it, EPI is so widely traded by a wide variety of market participants, that often there is significant two-way trading in the ETF that happens on the exchange. At the end of the day, dealers left with inventory in EPI may decide to hold on to their positions because they are confident that two-way demand in the ETF will continue the next day.
Now DLN is different and is a great example of a product that has tremendous underlying liquidity but does not trade significant volumes intraday. DLN provides exposure to the large-capitalization segment of the U.S. dividend-paying market. It has grown to a market cap of roughly $1.6 billion, but given its underlying exposure, DLN is most frequently used as a long-term investment vehicle. As a result, DLN does not typically trade significant volume intraday. Returning to the week of May 20, 2013, to May 24, 2013, DLN traded roughly $46 million in dollar notional volume for the entire week and had had roughly $15 million of inflows following a day of trading around 300,000 shares. This happens often. On a day when DLN’s volume spikes, it is usually followed by a creation or redemption order. While DLN displays less secondary market trading volume in the above example, it comprises the largest divided payers in the United States, some of the most widely traded stocks in the entire world. With an implied liquidity of 6 million shares, the underlying liquidity is absolutely there for large trades—investors just have to be smart about sourcing and accessing that liquidity. To do large trades in DLN, investors typically access liquidity providers that access the liquidity in the underlying markets to provide liquidity in the ETF. To use another example, on January 29, 2013, DLN traded 2.4 million shares in one day. When large shares are traded in DLN, we typically anticipate either a large creation or large redemption order the same or the very next day. As expected, on January 30, 2013, we saw the creation of roughly $112 million of new shares. The investor utilized a liquidity provider/market maker that accessed the liquidity in the underlying market and made the client a market on the secondary market; the client traded, and ultimately new shares were created in the primary market on the back of the big trade. By understanding the difference between the primary and secondary markets, you can better appreciate the difference between trading volumes seen on the exchange and potential underlying liquidity in the ETF. A more thorough understanding of ETF liquidity also sheds light on how a certain ETF may behave in different market environments.
It is important to remember that ETFs are a structure. Investors are not used to having this type of transparency in their investments. Because the ETF’s components are transparent, the securities that actually define the value of the ETF will help investors understand how the ETF may act on the secondary market. In most other investment products, investors rarely ever see real-time pricing of the investment. They typically see either a daily, monthly or quarterly NAV, and they do not have to worry about the real-time pricing of the investment on a daily basis. It is important to remember that broad capital market weakness is broad capital market weakness—ETFs are not somehow immune to that. They are a wrapper that is priced via real-time calculations (if the basket is open) or via fair value models (expectations). The wrapper price is based on the underlying, ability to hedge, the cost involved in the hedge, and the costs to create/redeem. Broad, systematic weakness affects all products and structures. Understanding the primary market function can help investors understand how the ETF will behave on the secondary market during normal times, and how it may behave during times of severe market stress.
Unless otherwise noted, data source is Bloomberg.
1David Abner, The Visual Guide to ETFs (John Wiley & Sons, Inc, 2013), 91