Poor liquidity metrics could mean lost opportunities

Institutional investors might be overlooking investment opportunities in exchange-traded funds because they are using inadequate metrics to gauge the funds' liquidity.

“Right now, many of the newer and smaller ETFs are completely ignored and dismissed by the (institutional) investment community because of perceived liquidity concerns,” said Paul Brigandi, senior vice president of trading at Direxion Shares, New York, which on Aug. 9 announced it closed nine leveraged ETFs with $20 million in total assets.

Investors might reject certain ETFs as lacking liquidity if the investor gauges it according to secondary-market criteria — the average daily volume of ETF shares traded and assets under management.

“It's kind of a self-fulfilling prophecy,” said Paul Justice, director of ETF research at Morningstar Inc., Chicago. “Institutions avoid those ETFs because they're small, and they don't get big because institutions avoid them.”

Institutional investors' proclivity for larger ETFs is apparent in a March report by New York's Deutsche Bank Securities, which shows institutions own 62.7% of ETFs with more than $20 billion in assets under management and 63.7% with monthly turnovers of $5 billion or more — the largest ETFs. But they own just 38% of ETFs with assets of $1 billion or less and 40.1% with turnovers of less than $500 million.

“By focusing exclusively on (average daily volume) and AUM, investors are not just overlooking smaller ETFs, but they are also failing to save costs on more efficient trade executions,” said Sebastian Mercado, ETF strategist at Deutsche Bank Securities.

Research from McKinsey & Co., New York, shows 82% of the 223 ETFs launched in 2010 failed to reach $100 million in AUM — a proxy for success—by the end of 2011.

Smaller ETFs have folded in recent months, which could add to long-term investors' concerns about investing in less seasoned funds.

Discount broker Scottrade Inc., announced Aug. 7 it would liquidate its FocusShares unit's 15 ETFs with $100 million in AUM. Ten days later, Russell Investments announced it was liquidating 25 ETFs with $300 million in AUM.

APG Asset Management, fiduciary manager for Stichting Pensioenfonds ABP, Heerlen, Netherlands, with e300 billion ($375 billion) under management, bases its ETF selections on AUM and ADV minimums, said a spokesman, who declined to provide numbers.

ETF liquidity might appear different to investors if they looked at a different measure of liquidity. Especially for the large-block orders, the liquidity of the underlying assets may be substantial even if ADV and AUM are low.

The Direxion Daily Total Bond Market Bear 1x Shares ETF, for example, had assets as of Aug. 27 of $17.81 million and ADV of less than 500 shares. However, it tracks the iShares Barclays Aggregate Bond ETF to gain inverse exposure, and that fund had $15.6 billion in assets and traded nearly 1 million shares.

The underlying assets' liquidity determines how closely to the market price market makers can buy or sell the underlying shares of an institutional client's ETF block trade and hedge the ETF position. If the underlying assets are highly liquid, the investor may receive a better price than trading the ETF shares directly.

The same dynamic applies to ETFs' unique creation/redemption process, in which investors tap approved participants — typically the major market makers — to enable the purchase or sale of blocks of at least 50,000 shares. The approved participants then tap liquidity sources to buy or sell the necessary underlying assets.

Some pension funds prefer or are required to invest in actively managed investments, including ETFs, and may use ETFs only temporarily while changing allocations. Marty Anderson, deputy chief investment officer at the $6.6 billion Arizona Public Safety Personnel Retirement System, Phoenix, said his fund doesn't screen ETFs using liquidity parameters. It uses broad-index, liquid ETFs as short-term “placeholders” while searching for new money managers.

ETFs are likely to become more vital to institutions' multifaceted investment strategies, requiring closer analysis of their underlying liquidity. Ogden Hammond, associate principal at McKinsey in New York, said smaller institutions have been more receptive to ETFs, perhaps as a part of a strategy to acquire exposure to new markets or geographic areas without having to create a separate account. He added that “niche” ETFs, such as those with single-country or single-sector focus, can also act as satellites around an institution's core investment strategy, expressing where a manager sees markets outperforming.