Beyond Bulls & Bears

LibertyShares

Getting Comfortable with ETF Liquidity

Many people put a lot of thought into the purchase of an asset—whether it’s a car, an investment vehicle or even a more mundane item—but might not think as much about what happens when they don’t want it anymore. David Mann, our Head of Capital Markets, Global Exchange-Traded Funds, draws some parallels between buying and selling an ETF and one of those mundane items: a mattress.

I have used restaurants and furniture stores as analogies for various elements of the ETF ecosystem and the buying and selling process. Now, I will add mattress shopping to that illustrious list!

Last month, my wife and I went mattress shopping, as our current mattress had just hit the 10-year mark and it was time for a new one.  As I started my research, I could not believe how much has changed within the mattress industry over the past decade, particularly the growing popularity of online mattress-in-a-box options.

Admittedly, we were hesitant to go the online route because of the inability to test the firmness of the mattress firsthand. Of course, the counter argument is how much can you really learn about the firmness of a mattress in five minutes in a showroom?

Whether online or in the showroom, all the options seemed to have essentially the same generous return policy—some version of “try it for 90 days and if you do not like it, return it for free.”

To me, this almost seemed too good to be true.  There were so many fantastic deals, but would the seller really buy it back from me at the exact same price I had bought it, no matter the condition?  There had to be a catch or some fine print—I was skeptical.

Buying and Selling an ETF

So what does this have to do with ETFs? When an investor is interested in buying large quantities of a newer ETF with lower average volume in particular, a question that’s often heard is, “Sure, you will help me get in, but will you be there when it is time to get out?” Specifically, will the ETF liquidity be there six months from now (or 90 days from now, or another time horizon) when the investor wants to sell?

I’ve repeatedly tried to encourage investors to think about liquidity in terms of the underlying basket of securities in the ETF, not just the ETF itself. And I’ve also reminded them that there is an ecosystem of market makers and authorized market participants who stand ready to add liquidity when needed.

But as much as we can talk about leveraging the liquidity of the underlying stocks or bonds for both buying and selling, there can be doubts until that day comes.

The good news is we have real-world examples that demonstrate what I have been talking about actually works in practice.  Last year, one of the early investors in Franklin FTSE Japan ETF (FLJP) decided to sell $50 million of their position. The bid/ask spread at the time of the trade was four cents wide, and the trade occurred within the bid/ask spread.

The transaction went smoothly, partly because of the aforementioned authorized participants and market makers, who helped provide liquidity for both the buy and sell side of the trades. That is their job!  They are adept at both creating shares when investors want to buy and redeeming shares when investors want to sell, even on days of heightened market volatility. Of course, we can’t guarantee every transaction will always be as smooth as this example, but it should provide some reassurance.

But back to mattresses. I heard directly from two friends that they had no issues returning their online mattress. The liquidity was as real as promised; the online store bought back their mattress at the exact same price it was sold to them, no questions asked. In fact, because that mattress liquidity (did I really just write that?) is real, there is now a whole “mattress ecosystem” developed to help handle those used mattresses, so they do not just end up in landfills.

Investors should have a similar level of comfort about ETF liquidity when buying—and one day selling—ETFs as well.

Important Legal Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

Any companies and case studies shown herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton Investments. The opinions are intended solely to provide insight into how securities are analyzed. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security. Past performance is not an indicator or a guarantee of future results.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

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What Are the Risks?

Franklin FTSE Japan ETF

All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in securities of Japanese issuers involve risks that are specific to Japan, including certain legal, regulatory, political and economic risks. Because the fund invests its assets primarily in companies in a specific country or region the fund may also experience greater volatility than a fund that is more broadly diversified geographically. These and other risks are discussed in the fund’s prospectus.

Investors should carefully consider a fund’s investment goals, risks, charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor, call us at (800) DIAL BEN/342-5236 or visit franklintempleton.com. Please carefully read a prospectus before you invest or send money.

ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns.

ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.

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