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Dispelling the ETF liquidity myth

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WisdomTree’s Zach Hascoe, Head of Capital Markets at WisdomTree Europe has written a note on the myth that ETF traded volume does equal ETF liquidity.

 He writes that it is the greatest myth in the ETF industry that trading volume equals liquidity when it comes to ETFs. 
 
“It is important for investors to understand that exchange volume and assets under management (AUM) rarely has an impact on the potential underlying liquidity of an ETF,” he writes. “ETF liquidity can be sourced from both the primary market (creation / redemption), the secondary market (stock exchange) and derivative markets.     Investors are narrowing their horizons by flocking to the most traded products and not considering new products with lower traded volume. Traded volume is traded volume, not liquidity.”
 
Looking at how different types of ETFs can serve different purposes depending on the exposure they provide, Hascoe comments that some ETFs are used primarily for hedging and intraday portfolio trading. “These ETFs typically track major world benchmark indexes, and they can trade millions of shares per day. ETFs can also be structured more as investment vehicles and don’t typically have very high average daily trading volumes. Investors make investments into these 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 equally traded 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.”
 
He writes that when an ETF is launched, it is typically launched at a low asset level. Once the ETF goes live, it has no trading history and a low AUM level. “This however does not affect the potential underlying liquidity that inherently exists in the ETF.  ETF liquidity can be sourced very efficiently through its underlying securities, and large trades can be done with ease for investors. Depending on the underlying basket, trades can often be executed efficiently which are greater than the average daily volume of the ETF and larger than the current assets under management of the ETF. This is because the ETF market makers or authorised participants (APs) are sourcing the liquidity of the underlying basket and extrapolating that into ETF liquidity for the investor.”
 
 APs have the right to create and redeem to demand. APSs buy and sell ETFs to demand and often in advance of a creation or redemption. “By hedging in the underlying markets they can price ETFs dynamically to satisfy this demand and flatten the hedge by creating new units at the end of the day. This occurs many thousands of times a day in the ETF industry and there are many global leading trading firms with expertise in ETF trading that facilitate this for clients.”
 
Hascoe finds that investors can still be sceptical that a large trade/investment can be done efficiently on an ETF with low daily volume and a low AUM level. “This is because ETFs trade like equities so historically, the common approach to buying equities is to use the daily average volume as a threshold for making an investment that doesn’t impact the underlying prices. This thinking has been erroneously applied to ETFs. However, it should only be applied to the underlying equities or assets in the ETF basket which represent the index or benchmark being tracked. This measures true ‘implied liquidity’.”

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