Beyond Bulls & Bears

ETFs

Don’t Fear the ETF Liquidity Boogeyman

Selling an exchange-traded fund (ETF) should be just as easy as buying one, irrespective of the fund’s size or volume. David Mann, Head of Global ETF Capital Markets, discusses why investors need not fear some unknown future event when making today’s investment decisions.

This blog/newsletter covers a wide array of ETF-related topics, but the subject we feel compelled to keep returning to is liquidity. This topic was discussed in my very first post (“What Investors Look for in an ETF”) on the misconceptions of using trading volume to determine ETF liquidity as well as my most recent one on better ways to keep score (“Moneyball: The Art of Analysis in ETF Trading and Liquidity”). In between, there have been dozens more.

I tend to focus my posts on specific elements within the ETF liquidity narrative so that investors will keep an open mind when selecting an ETF beyond those with the most volume or assets. There are numerous examples and case studies within the industry supporting this claim. However, there is one pushback we sometimes receive that can be difficult to counter: Will liquidity be there when it is time to sell?

I consider this the “Boogeyman” of ETF liquidity. “Oh sure, it is easy for me to buy this ETF today, but how do I know I’ll be able to sell my position later?” The challenge is that any example of investors selling their ETF positions with minimal market impact are from the past and do not contemplate some unknown market event at some unknown day in the future. How do you disprove an event that hasn’t even happened?

Skipping to the conclusion, selling an ETF should be just as easy as buying one, as there is nothing inherent within the ETF structure that would make selling more difficult than buying.

What if there are no buyers?!

I speculate that the Boogeyman itself—the main concern investors have—is that there will not be any buyers when they want to sell. The good news is that a proper understanding of ETF arbitrage can show why this concern is unwarranted. ETF liquidity providers do not want to take directional market bets. Their business model is to determine the “fair value” of an ETF based on the price of the underlying securities, provide a two-sided market around that value, and then hedge their risk accordingly based on the amount of buying and selling.

There is no need to worry about whether there will be any buyers on some future day because we don’t really need buyers (in the traditional sense of the word)! When investors are looking to sell, ETF market makers are simultaneously buying the ETF and selling the underlying basket (or some other highly correlated security). Likewise, the same dynamic would happen the other direction with ETF market makers selling the ETF while buying the underlying basket.

Can market uncertainty overwhelm the normal ETF arbitrage mechanism?

As always, I am going to add a caveat. ETF trading works like this almost all the time. The reason I say “almost” is that we have seen a few, rare instances over the past few years when market uncertainty overwhelms the normal ETF arbitrage mechanism. We saw that back in March of 2020 (The ‘New Normal’ for ETF Trading?”) and then earlier this year with some ETFs that hold Russian securities (Clearing the Inbox: ETFs that Hold Only Russian Equities”).

In times of extreme market uncertainty, the ETF arbitrage mechanism for ALL ETFs becomes impacted, irrespective of size or volume. This was the main takeaway from the 2021 International Organization of Securities Commissions report that highlighted ETF trading behavior during March 2020 (“The Liquidity Unicorn: Are any ETFs Truly Bulletproof During Market Stress?”). No ETFs are immune to such conditions—even billion-dollar ETFs with hundreds of millions of daily trading volume experienced excessive discounts to net asset value.

The ETF liquidity Boogeyman who thinks there might be trouble selling an ETF on some random day in the future does not exist (even if you chant its name three times!). The real concern is the occurrence of a market-wide event leading to excessive uncertainty across all ETFs.

 

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.

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. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data.  Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

Get Content Alerts in My Inbox

Receive email alerts when a new blog is posted.