Page 44 - DIY Investor Magazine | Issue 32

WHY SMALL ETFs ARE NOT NECESSARILY LESS LIQUID
Mark Abssy, Head of Indexing at Tematica Research and Co-Manager of the Tematica Bita Cleaner Living Sustainability Screened Index
If you think back to the first time you heard about Exchange Traded Funds (ETFs) they were probably explained to you
as ‘similar to mutual funds but they trade like shares on an exchange.’ For the most part, this is true. Mutual funds have a single official daily net asset valuation (NAV) that is used by all buyers and sellers on the day.
If you want to buy or sell a mutual fund, you enter your trade and it will be filled at the end of day using that day’s NAV. In contrast, ETF share prices are live continuously throughout each trading day based on an intraday NAV that should reflect the fund’s underlying holdings.
As a result, ETFs are more similar to individual shares, being traded throughout the day. But this comparison stops working when investors make assumptions about comparing individual share and ETF share liquidity.
MORE BUYERS THAN SELLERS
Often when you ask why shares of a public company rose you will get the response that ‘there was more buyers than sellers.’ Everyone has a chuckle, and it is understood that the person you are asking either doesn’t want to share their insight into the company or simply doesn’t know.
The truth of it is that regardless of the motivation of traders, there were indeed more buyers than sellers and that demand for shares is what drove that price up.
If we reach back to Economics 101, we remember that given a fixed supply, an increase in demand will cause the perceived value of that supply to increase. This principle plus a whole bunch of correlation tables are how market makers do their voodoo and put a price on shares. ETFs are slightly different. When it comes to ETFs, if there are more buyers than sellers, more shares get created. ETFs launch with a fixed amount of shares.
‘IF THERE ARE MORE BUYERS THAN SELLERS, MORE SHARES GET CREATED. ETFS LAUNCH WITH A FIXED AMOUNT OF SHARES’
However, market participants can create and retire shares through what is known as the Creation/Redemption process. The shares of an ETF represent ownership of a portfolio of securities referred to as a ‘basket’.
Basically, when there is an imbalance in an ETF order book (more buyers than sellers, for example) the share price will start to deviate from the actual value of the assets (NAV) of the fund. Once the premium gets high enough, market participants step in, buy the basket of stocks that the ETF tracks and trade the underlying basket of shares for shares in the ETF. They will then take these ETF shares and sell them on the open market, pocketing the difference.
Crucially, however, this whole process keeps price and NAV in line. First, it puts downward pressure on the ETF’s share price, hopefully pushing it closer towards the NAV. Second, it puts upwards pressure on the underlying shares in the ETF, as the whole process has seen market participants purchase these shares in the market. This process will be repeated until price and net asset value converge. Once they do, the arbitrage gap narrows.
I TOLD YOU THAT STORY SO I COULD TELL YOU THIS ONE
Equity liquidity can be measured a few different ways. For example, some may look at market capitalization and share volume and others may look at bid/ask spread. Overall, the goal in evaluating equity liquidity is to make sure that any single trade isn’t going to have an undue impact on the stock’s price (affect price discovery).
DIY Investor Magazine · Feb 2022 44