Assessing ETF Liquidity and Large Institutional Trades

Risk.net this week published its second annual Global Exchange-Traded Fund (ETF) Trading Survey, commissioned by Jane Street.

The analysis includes responses from nearly 300 institutional investors, as well as qualitative interviews from 14 investment management firms.

According to the paper, “competitive pricing” remains the most important criterion for institutional investors when choosing which ETF products and providers to utilize, with 55% of institutions putting it in first place. Institutions value competitive pricing twice as much as any other criteria, Risk.net reports, including “expertise in complex/illiquid markets” (20%), “ability to trade in large size” (16%) and “value-add services” (9%).

In the institutional investor market, Risk.net finds the size of the average ETF trade has grown substantially even since last year. Fully 24% of global institutions report having executed a trade over $100 million, compared with 21% in the year prior. Notably, in the U.S./Americas market segment, 4% of respondents have executed an ETF trade in excess of $1 billion.

The Risk.net white paper says part of the appeal of ETFs is that they offer investors exposure to a series of assets in a single security.

“Another is the ease with which they can be traded,” the white paper says. “Buying or selling ETFs referencing bonds, commodities, or emerging markets assets can be as easy as trading a stock.”

Asked what type of ETFs were more efficient to trade than the underlying asset, U.S.-based institutions ranked fixed-income ETFs first on the list. Emerging markets followed closely in second place, then developed markets, which were ranked third.

The white paper offers a few important warnings for institutions thinking about using ETFs and trying to understand ETF liquidity relative to other investment vehicles.

“The efficient trading of ETFs starts with an understanding of a fund’s liquidity. This informs pricing, tracking error and a firm’s overall assessment of the risk of taking on a specific position,” the white paper says. “Institutions have an array of metrics to gauge an ETF’s liquidity. Top‑level indicators include the fund’s bid-offer spread, average daily volume and assets under management. However, these only give firms a superficial view of a fund’s liquidity. To gain a better understanding, it is prudent to consider the liquidity of the underlying securities, also known as ‘implied liquidity.’”

According to the white paper, globally, 31% of respondents say they now look at the underlying securities to evaluate the liquidity of an ETF, up from 27% in 2017. Firms in the U.S. and Europe propelled this growth.

The white paper concludes the institutional ETF marketplace will grow ever-more sophisticated with regard to counterparty selection, fund liquidity evaluation and execution methodology.

“This year’s findings reveal a focus on best execution and costs across the entire industry, leading investors to a more granular understanding of which counterparties are best suited to carry out ETF trades,” the white paper says. “Larger and more complex trades create an advantage for firms that specialize in ETFs. Institutional desire for price and cost certainty and a better understanding of liquidity have driven an uptick in risk pricing. Looking ahead, as institutions increase their use of ETFs, it will be interesting to evaluate how these trends evolve.”