Should I: Worry about the low liquidity of UCITS ETFs?

The Bottom Line

We think most retail investors (portfolio <S$10 million)  should not have any difficulty trading in and out of the ETFs we have recommended for their core, passive portfolios.

London listed Irish UCITS ETFs have to appoint one or more market makers who must provide competitive and continuous two way quotes for the ETF. These quotes need to meet the minimum size and maximum spread requirement of LSE.

The market makers can use liquidity of other share classes of your ETF and of similar ETFs in other markets to hedge their positions. They can also work with Authorized Participants to create or redeem the ETF shares if they need to manage their exposure.

As a result even if your trade is large relative to the daily liquidity of an ETF, you should be able to get liquidity from a market maker. This could lead to slightly higher trading cost but the long term total cost of ownership for most UCITS ETFs should still be lower than for US ETFs.

This assessment may not hold for ETFs issued by less established fund managers or for ETFs where the underlying asset is hard to trade or hedge.

Should I worry about the low liquidity of UCITS ETFs?

Are Irish UCITS ETFs liquid enough? That’s a big question for many investors when they choose ETFs for their portfolios. It was also the biggest concern in response to our suggestion that retail investors should prefer UCITS ETFs over US ETFs in most cases.

The average daily traded value for the UCITS we recommend is usually about 1/50th of a similar US ETF we recommend as an alternative. For example, EIMI LN trades US$6.3 million on an average day. VWO US trades more than US$550 million a day or about 88 times as much.

Table 1: Liquidity Comparison – UCITS ETFs vs. US ETFs

We explain below why it may be acceptable to have lower liquidity thresholds for ETF vs. for stocks. But first, why is liquidity important?

Why is liquidity of a stock important?

Because it can impact your ability to enter or exit your position and it can impact the price you receive when buying or selling.

For example, lets say you want to sell $200K of a stock that trades only $100K a day. This will be difficult.

If you put the entire $200K in a single sell order, the price of the stock may collapse as the market realizes that the supply of the stock in more than the demand. Existing buyers may pull their orders or lower the price limit at which they want to buy.

If you split this into multiple sell orders that are more manageable on a daily basis, that creates a lot more work for you. Now you need to enter the orders every day and track their execution. You need to figure out how much you can sell every day. $10K? $20K? More?

That $100K trading volume is an average. You may run into multiple days when the volume is much lower – maybe $20K or $50K.

The market may move against you over the days that it takes to complete your trade. If you show up every day with an order that’s large relative to the daily trading value, after a few days the market may realize that there is a big seller and the stock’s price may collapse any way.

The bid-ask spread can also be higher for less liquid instruments leading to higher trading costs.

These problem can also apply when you’re trying to buy but typically buying tends to be easier than selling. Also for a core passive portfolio, you will likely buy small amounts of an ETF over a long period so low volume will not be as much of a problem as it will when you need to sell a much larger position accumulated over years.

Finally, even if you don’t need to sell, someone else may want to sell a large amount and that could cause the price to collapse temporarily, making it emotionally painful for you and possibly hurting your ability to hold the position.

For all these reasons, it is important to be sure that the stock you’re investing in has enough liquidity to support exiting your position without much difficulty.

Does the same logic apply to ETFs?

Yes and no.

Yes because all things equal, a more liquid ETF is better than a less liquid ETF, just as for a stock. A more liquid ETF will be easier to sell with less market impact from your or anyone else’s large order.

No because ETFs are different from stocks in some important ways that reduce (but not eliminate) many of these risks.

Since the liquidity of US ETFs is more than adequate for most of us, the rest of the discussion in this sector relates to London listed Irish UCITS ETFs.

Market Makers A condition for listing an ETF on the LSE is that the issuer should arrange at least one registered market maker for the ETF from the first day of listing onwards. Issuers are advised to have at least two registered market makers to ensure competitive pricing and so that if systems of one market maker go down, the market for the ETF still functions.

The market makers have to “provide continuous bid-offer orders throughout the trading day in a minimum size and maximum spread regime.“

In other words every ETF listed on LSE will have at least one market maker providing a continuous two-way quote during market hours. So if you want to sell, you can take comfort in knowing that there will be at least one buyer for your shares.

What does “minimum size and maximum spread regime” mean?

Minimum size means that the market maker must be willing to buy or sell a minimum specified number of shares of the ETF at the price they are quoting.

Maximum spread means that the gap or “spread” between the price at which they are willing the buy and the price at which they are willing to sell cannot be more than a certain percentage of the price.

In other words, they cannot fulfill their duty by offering to buy, say 1 share of VWRA LN at $1 and sell 1 share at say $1000, when the price of VWRA is $100.

If the maximum spread is say 3%, the quote to buy VWRA shares (the bid) will likely be more than $98.50 and the quote to sell the shares (the ask) with likely be less than 101.50.

Of course there is no obligation to offer the quote close to the last traded price for a security, so the bid-ask could be $48.50 and $50.00 even though the last trade is 100. But in that case they would need to sell the minimum size at $50.00 if someone decides to buy. So the incentive is to stay close to fair value unless the last trade was long ago or if the market has moved sharply.

We were unable to find specifics of the minimum size and maximum spread for the ETFs we recommended. It was not disclosed in the prospectus, annual report or factsheet of the funds and also wasn’t available on LSE website.

We have reached out to LSE for this information and will update here if we get a response.

According to this document the maximum spread should be between 1.5-5%. To be clear 5% is a lot – the bid-ask spread for VWRA is around 0.2% at the moment. We would not trade an ETF with a 5% bid-ask spread.

Since most of the ETFs we recommend at from large asset managers like iShares (Black Rock) and Vanguard, we assume for now that they will all have at least 2 market makers for each ETF and their ETFs will be subject to a maximum spread of 1.5%. That is still very high. In reality these ETFs should have a lower effective spread but in times of market stress it could spike closer to 1.5%.

This means that in most cases there should be sufficient liquidity for retail investors when they need to exit, no matter what the reported daily trading volume of an UCITS ETF is.

While there may still be some market impact from a large order, it should not overcome the advantage UCITS have on 15 year total cost of ownership.

Authorized Participants (APs) are another set of key players in the ETF ecosystem. Each ETF must appoint one or more APs. APs are allowed to go to the issuer (iShares or Vanguard) and get them to create or redeem ETF shares.

To create an ETF share, the AP must buy the underlying basket of shares that make up the ETF and give them to an issuer, getting the ETF share in exchange. To redeem, they give the ETF share to the issuer, and get the underlying share basket in return. Usually they will then sell these shares and get cash.

For e.g. if the AP gives iShares (the issuer) some CSPX LN shares, the issuer will give them back an equal amount made up of shares of all 500 S&P 500 constituents, in the proportion that they are present in the S&P 500 index. They can then sell these in the market and get the cash.

This allows them to arbitrage the price of the ETFs and the underlying shares that make up the ETF and ensures that the share price of the ETF does not diverge too much from the underlying index it tracks.

The way this works is that if a lot of people are trying to sell the ETF shares, the market makers will buy those shares, maybe at a small discount to the NAV . If they don’t want to hold all those ETF shares on their balance sheet, they can simply go to the AP and ask them to redeem the ETF shares.

The AP will follow the process of redeeming and give the resulting cash (equal to the NAV of the ETF) to the market maker. Since the market maker had purchased the ETF at a small discount to its NAV, they make a small profit in this transaction.

What this means is that even if an ETF is very illiquid, market makers should be willing to take the other side of a large sell order at a small discount, knowing that they can redeem the shares via the APs in case they cannot find a buyer.

So they take very little risk buying an illiquid ETF in the market. This is different from buying an illiquid stock in the market, where the risk would be a lot higher and could stop them from taking the other side of your trade.

Underlying Fund liquidity & Share Classes Many UCITS have multiple share classes e.g. one that distributes dividend, one that reinvests dividend (accumulating), some denominated in GBP, USD, EUR etc.

In our analysis of the best ETFs we have looked at the liquidity of only the most liquid share class for each ETF.

However, the underlying fund is identical for all of these share classes and the market makers should be able to hedge trades in one class by trading another class. This means the liquidity that may really matter is the combined liquidity of all the share classes.

What’s more, if the same issuer (or even another issuer) offers an ETF tracking the same index in US, the market makers could have the ability to hedge their exposure in London by trading the ETF in US (only when UK & US trading hours overlap, of course).

All this means that a large sell order is unlikely to have as much impact on an ETF as it would have on a similarly illiquid stock. An active market maker willing to take the other side of your trade is also more likely to be present for an illiquid ETF than for an illiquid stock.

This does not guarantee that you will always get an efficient execution on an UCITS ETF. However we would be comfortable assuming that in most cases the UCITS ETF will remain the cheaper option compared to US ETFs, even after accounting for some inefficiency in execution because of lower liquidity.