Looking for liquidity in all the wrong places

Misconceptions about liquidity make it for new ETFs.

October 4, 2012

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internet search computer“Right now, many of the newer and smaller ETFs are completely ignored and dismissed by the (institutional) investment community because of perceived liquidity concerns.” This is a quote given to Pensions & Investments by a dejected-sounding Paul Brigandi, senior vice-president of trading at Direxion Shares in New York, a firm that just closed nine leveraged exchange-traded funds (ETFs). Firms like Brigandi’s are under tremendous pressure in the ETF space as institutional investors wisely start to look under the hood, scrutinizing everything from share creation to liquidity.

But liquidity isn’t always what it seems in the world of ETFs and misconceptions around what exactly ETF liquidity looks like could be preventing new players from growing to their full potential—so argues Brigandi and other providers who believe more education is needed in the space. Indeed, recent data shows just how tough the ETF world has become as scores of new entrants arrive on the scene and fail to attract much attention (or money for that matter). The following is a few recent statistics:

  • according to the Financial Times, 27% of all ETF products listed in the U.S. and open longer than six months are economically unviable, with 377 products generating just $35,000 in revenue;
  • McKinsey report notes that, in 2010, 82% of new ETFs failed to reach $100 million in assets; and
  • in August, Russell Investments closed its passive ETFs. Scottrade also announced over the summer that it is shuttering its ETF business. In Canada, 11 ETFs have already closed this year or announced they will be closing.

This brings us back to the liquidity question. One of the biggest barriers to success, say many industry players, are fundamental misconceptions about what makes a product liquid. And those providers have one big message for investors. A lack of trading volume in an ETF doesn’t mean it’s not liquid. Rather, an ETF is as liquid as its underlying components. If the underlying assets in the ETF are highly, then investors have a better chance of getting a better price when trading the shares.

For pension funds using ETFs as a placeholder during a new manager search, however, liquidity concerns might not be front and centre—at least they’re not top of mind for the $6.6 billion Arizona Public Safety Personnel Retirement System, which told Pensions & Investments that his fund doesn’t screen ETFs using liquidity parameters. But for Canadian pension funds looking closely at ETFs, liquidity should be paramount. They just need to make sure they’re looking in the right place.

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