ETF Versus Stock Liquidity

Exchange traded funds (ETFs) have undeniably revolutionised the investment landscape for both investors and financial services professionals alike. They offer opportunities to diversify portfolios, manage risk more effectively, and reduce investment costs. However, to fully harness these benefits, it’s crucial to dispel confusion and misconceptions surrounding ETFs Liquidity. The article examines the working of ETFs, their liquidity and how investors can capitalise on them 

The past fiscal year witnessed remarkable performance in the Indian equity market, with all the equity indices showing gains. However, what truly stole the spotlight were the broader market indices and public sector undertakings (PSUs). This bullish trend in the equity market was mirrored in the inflows into equity mutual funds. Last year, dedicated equity mutual funds experienced a net inflow of ₹1.84 lakh crore, marking a significant 25 per cent increase from the previous fiscal year’s inflow of around ₹1.49 lakh crore. 

Another notable trend in the mutual fund landscape is the rising popularity of exchange traded funds (ETFs). ETFs, which track benchmark indices, offer returns closely aligned with market performance. The assets under management (AUM) of index ETFs surged from ₹50,211 crore in FY17 to ₹695,205 crore as of March 2024, reflecting an impressive annualised growth rate of over 50 per cent. This growth in AUM can be attributed partly to the rising equity indices, contributing to mark-to-market gains. 

During the same period, key indices like Nifty and Sensex demonstrated compounded annualised growth rates (CAGR) of 18 per cent and 20 per cent, respectively, while BSE 500 saw a CAGR of 20 per cent. The difference in the growth rate between the ETF’s AUM and indices clearly underscores the continued strength of inflows into ETFs. Over the past eight years leading up to FY24, ETFs attracted a cumulative inflow of ₹3.74 lakh crore, accounting for nearly 50 per cent of the current ETFs AUM. Notably, a significant driver of this increase is the participation of the Employees’ Provident Fund Organisation (EPFO) in equity investments through passively-managed ETFs. 

Despite the significant number of folios associated with ETFs, with 1.28 crore in total, retail investors dominate this space, accounting for over 1.25 crore folios, or 98 per cent. However, when examining the AUM distribution among various stakeholders in index ETFs, a striking contrast emerges. Corporates hold a substantial 91 per cent share of the overall index ETF AUM, with high-net-worth individuals (HNIs) and retail investors comprising just 7 per cent and 2 per cent,respectively. The relatively low participation of retail investors in ETFs can be attributed to a lack of awareness and understanding of these investment instruments. Many investors mistakenly equate ETFs with individual stocks, leading to confusion regarding liquidity traits. Contrary to this belief, ETFs exhibit distinct liquidity characteristics, often misunderstood by retail investors. 

Liquidity in ETF
Securities liquidity is a measure of how easily you can buy or sell them without significantly affecting their price. Impact cost, a key metric in assessing market liquidity, provides a more accurate picture of execution costs compared to bid-ask spreads. Securities with higher liquidity offer the advantage of minimal impact cost, ensuring swift transactions with tight bid-ask spreads. Maintaining low impact cost is paramount for investors, as enhanced liquidity shields securities from drastic price fluctuations caused by substantial trade orders. Even though both equities and ETFs trade on stock exchanges, their liquidity characteristics differ markedly. ETFs boast a distinctive creation and redemption mechanism, setting them apart from stocks. 

This mechanism ensures that ETF liquidity is notably deeper and more dynamic than that of individual stocks. ETFs operate within a fundamentally distinct ecosystem compared to other exchange-traded instruments like stocks or closed-end funds. Unlike these securities, which have a fixed supply of shares, ETFs are open-ended investment vehicles capable of issuing or redeeming shares on the secondary market in response to investor demand. This flexible structure underscores the unique liquidity dynamics inherent to ETFs, underscoring their resilience in various market conditions. Crucially, an ETF’s liquidity is primarily influenced by the liquidity of its underlying securities, rather than its asset size or trading volumes. 

ETF Liquidity
Several misconceptions persist regarding ETF liquidity, with one of the most prevalent myths suggesting that lower daily volume or AUM indicates ETF illiquidity, akin to less-traded stocks with lower market capitalisation. However, ETFs differ fundamentally from individual stocks, and these differences directly influence ETF liquidity. As discussed in the above paragraph, while stocks might have limited supply over a shorter period in the secondary market, ETFs do not suffer from this limitation. They are open-ended investments such as mutual funds and can be issued or withdrawn from the secondary market according to the supply or demand situation. 

Therefore, if there is demand for a particular ETF, it can be created and issued. As such, the trading volume or AUM of an ETF alone cannot determine its liquidity. It is the underlying security which forms the ETF and determines its final liquidity. A case in the point is ICICI Prudential Nifty 50 ETF, which had an AUM of ₹14,024 crore at the end of March 2024. In the last one year ending May 8, 2024, on an average, 19,000 ETFs were traded and in almost one-third of the time this ETF barely traded in five digits or beyond 10,000. Now the question is whether this ETF will suffer from lower liquidity in case of higher demand for the ETF? 

The answer to this question is that there will be no liquidity issue. This is because the underlying securities that are Nifty 50 constituents may have enough liquidity to create the right amount of ETFs without much of an impact cost. This can be better understood if we examine the working of ETFs and how are they issued and withdrawn. The units of ETFs are created when professional investors—known as authorised participants (APs)—place an order directly with the ETF manager. In exchange for payment, the AP receives ETF shares, which can then be sold by the AP into the secondary market, as illustrated below. 

Therefore, the ETF volume that an investor sees on the screen might not reflect the correct liquidity of the ETF. The AP can create more and more ETFs as per the demand. This unique creation and redemption mechanism means that ETF liquidity is much deeper and much more dynamic than stock liquidity. It also explains why an ETF’s liquidity is predominantly determined by the liquidity of its underlying individual securities, rather than by the size of its assets or by trading volumes. 

Ample Liquidity Available in Well-Traded Underlying ETFs
While the on-screen bid-ask spread might seem like the full picture of ETF liquidity, there’s more to the story. Large investors can access significant ‘hidden liquidity’ by directly contacting APs or fund companies to create or redeem large ETF blocks. For smaller investors relying on the secondary market, there’s still good news. Market makers, who maintain buy and sell orders (bids and offers), typically show only a fraction of their actual trading capacity. They might display quotes for a small number of shares, even though they are willing to trade thousands at the same price. This helps them manage risk from sudden market movements or algorithmic trading glitches. In simpler terms, the visible order book doesn’t represent the full picture of ETF liquidity. Both large and small investors can potentially access more liquidity than what’s initially apparent. 

Image: Source: American Century Investments

Tips to Buy ETFs 

1) Don’t use trading volumes or fund size as a guide : - We have explained in detail how one prevalent misconception about ETFs is that those with low daily trading volumes or minimal assets under management will pose challenges or incur high costs when traded. This is largely untrue. Through the ETF creation and redemption mechanism, even ETFs with low trading volumes can efficiently accommodate large buy or sell orders, maintaining prices closely aligned with the net asset value of their underlying securities. 

2) Focus on total ETF liquidity : - Market makers, pivotal in maintaining constant bid and ask prices for ETFs, often reveal only a fraction of their trading volume on the exchange platforms. Consequently, secondary market liquidity may exceed what on-screen data indicates. Moreover, investors executing large ETF trades can access primary market liquidity by collaborating with authorised participants to directly create or redeem ETF shares with the fund company. Hence, while selecting an ETF to invest, focus on total ETF liquidity instead of what is visible on the screen. 

3) Opt for limit orders as the primary order type when trading ETFs : - A limit order allows investors to set a specific price or better when buying or selling a predetermined number of shares, providing control over the trade execution price. Conversely, a market order executes immediately at the prevailing market price, potentially resulting in unexpected execution prices as it interacts with existing orders on the order book. In case of not so liquid ETFs, a market order may get you a favourable trade. 

4) Be mindful of the timing when executing ETF trades : - As a general guideline, trading during periods when market makers and institutional investors find it challenging to hedge underlying securities in an ETF may lead to wider spreads and less efficient trades. These periods often occur just after the opening and just before the closing of the equity markets. Therefore, it is recommended not to trade during this time. 

5) Before executing a trade, check the intraday or indicative net asset value (iNAV) : - As ETFs trade in real-time, it’s essential to have a benchmark to assess whether the market price displayed on your trading platform is fair. The iNAV serves as this benchmark, typically updated by asset management companies (AMCs) every 10-15 seconds and made available on their websites. The iNAV is calculated as follows: the last traded price of all securities in the ETF basket multiplied by the number of shares in the ETF creation basket, plus the cash component (unused cash in the ETF), divided by the total ETF shares in the creation basket. Essentially, the iNAV provides a real-time NAV, allowing you to compare it with the current market price on the stock exchanges and make informed trading decisions. If the difference between iNAV and the price is huge, it’s a red flag. The image below shows the actual bid and ask price of SBI Nifty 50 ETF and it iNAV displayed in AMC’s website at the same time. In the below mentioned case you can see the actual trade is happening are very close to iNAV, which is good for those who want to take exposure to this ETF. 


Image: Source: https://etf.sbimf.com

Conclusion
ETFs have undeniably revolutionised the investment landscape for both investors and financial services professionals alike. They offer opportunities to diversify portfolios, manage risk more effectively, and reduce investment costs. However, to fully harness these benefits, it’s crucial to dispel confusion and misconceptions surrounding ETFs.