Beyond Bulls & Bears


Moneyball: The Art of Analysis in ETF Trading and Liquidity

What does baseball have in common with exchange-traded funds (ETFs)? David Mann, Head of Global ETF Capital Markets, steps up to the plate to explain—and clear up some misconceptions about trading and liquidity.

Baseball opening day has finally arrived, and I cannot wait to get back out to the ballpark. Even my wife has finally come around to the joys of watching the Oakland A’s on a summer weekend afternoon while having a hotdog with an ice cold beer. The kids are always decked out in full gear with baseball gloves on hand to catch any stray foul balls.

Last season was the first time I noticed that some new stats had made their way onto the main scoreboard when a player came up to bat. The old favorites, like batting average and RBIs, were still there but new “advanced stats” were now included in the mix: OPS (On-Base Plus Slugging), WAR (Wins Above Replacement), and BABIP (Batting Average of Balls in Play).

For decades, batting average was the most important stat when determining the offensive prowess of a batter. A .310 hitter was better than a .280 hitter who was better than a .250 hitter—end of story. Only recently (call it the last 20 years) has the baseball world come to appreciate that batting averages ignore a lot of important offensive elements such as walks, speed and power. Those newer metrics do a better job of showing that a .260 power hitter who walks frequently can have more value than a .310 singles hitter who never walks.

But at the same time, knowing that a batter has a .310 average still has real value—in fact, that player is probably an all-star! That’s why batting average is still very popular and is used in conjunction with additional statistics that together can tell a better narrative.

At this point, you’re probably wondering if you’re even reading the right newsletter. Where is the part on ETF trading and liquidity?! I would argue that for the most part, the ETF industry has decided that the most important stat for trading purposes is average volume followed closely by bid/ask spread. And I’ve spent the better part of the last five years writing articles to point out the misconceptions associated with those trading statistics (in fact, average volume was my very first blog post back in 2016).

But just because volume does not tell the whole story when determining the ease of buying or selling an ETF does not mean that it has no value at all. It most certainly does. This raises two additional questions:

  • What value can be gleaned from average trading volume?
  • If using that stat alone won’t suffice, is there a better way to gauge true liquidity?

For my answers, consider some baseball parallels. Let’s say that our .310 hitter was coming up to bat in a tight game. In from the bullpen comes the lefty reliever who throws sidearm. A graphic then pops up on the television showing that the .310 batter hits only .115 lifetime against sidearm lefties. The .310 average indicates that this is a solid hitter but that is a very broad brush across hundreds of plate appearances. But just as Brad Pitt in the movie “Moneyball” may have rejected that single stat as a sufficient gauge, we’re better served drilling down to this specific at bat against this specific pitcher in this specific ballpark at this specific time of the day. When we do, we see the .310 stat becomes somewhat less relevant.

I think this analogy applies to using historic average trading volume to measure ETF liquidity. Those numbers reflect how much trading other investors have done in the past. Although a large average volume number paints a narrative of trading ease, many of the trades that are part of that calculation may not be relevant to trading today. An investor who wants to buy/sell a specific amount of an ETF at a specific time could have very different experiences from one day to the next. That’s why in even the most heavily traded ETFs, purchases of the same size can sometimes occur on the offer and other times at pennies over the offer, depending on that day’s market conditions.

To answer our first question above, high trading volumes are a very solid stamp of approval to show that trading should be relatively straightforward—just like a high batting average indicates a solid hitter. However, as the size of the trade increases and the level of market uncertainty rises, the value of that statistic drops significantly. That is exactly why our .310 hitter might struggle against that lefty reliever.

That is a perfect segue to our second question. Certainly, there are potential additional statistics that investors can use to get to a better idea of an ETF’s true liquidity. As mentioned earlier, singular trades can vary depending upon market conditions. Thus, looking at multiple trades of the same approximate size over an extended period can be a much more accurate indicator of the costs to trade a particular ETF. To normalize across funds of different price points, the average trade execution relative to the mid-point of the bid/ask spread can give investors a clearer idea of the costs to buy or sell a particular fund. For an acronym akin to baseball parlance, perhaps, the STREAM?? (Size-based Trading Relative Execution Away from Mid-point).

Average trading volume is an important factor in an ETF’s liquidity profile but does not tell the entire trading story. Utilizing additional historic metrics can show that often trading costs can be quite similar despite very different average volumes. Investors can thus have confidence in using funds that don’t have the highest volume, just as fans of the Rangers should not stress when signing former A’s who bat .265.

What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those offering potential for higher returns are accompanied by a higher degree of risk.

For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.

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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