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    • June 20, 2024
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      On-Screen Vs. Implied Liquidity

      At HTAA, we spend most of our days working on our alpha signals with the goal of delivering worthy models for clients. And at the same time, we realize the importance of execution and how that could potentially impact their experience. We broached the topic of the creation/redemption process and ETF liquidity in a twitter article, “ETFs and Liquidity.” We’d like to continue the conversation by discussing tips for trading less liquid ETFs.

      Let’s start with a simple anecdote. Say you are trying to reward your employees for having a successful quarter and want to buy each of them a gift. You walk into a stationary store and notice a nice gift basket. It has a bottle of wine, a box of chocolates, a bag of Colombian coffee and a cute tumbler. However, you only see one of them assembled in the store and you have 20 employees. Do you just abandon the mission and leave? No. Most likely you’ll find a store employee and ask them if they can assemble 19 more of these baskets for you. Assuming they have all the individual components in the store, they will gladly oblige and charge you a price equivalent to the individual component plus a small assembly fee.

      You may encounter a very similar situation when looking for exchange traded funds (ETFs) for your or your clients’ portfolios. You might find a product that you like but when you go to the exchange you will see that the market maker is only offering to sell 1000 shares. These 1000 shares are what financial professionals will often refer to as “on-screen liquidity”. Similarly to the stationary store example, there is no need to panic. Depending on what is in the ETF basket (instead of wine, chocolate and coffee it may be something like a stock or another ETF of T-Bills), it may be very easy for the store employees (in our previous post we referred to them as Authorized Participants) to assemble more baskets. If you counted all available inventory of the basket components, you could calculate the so called “implied liquidity” for an ETF. If the individual components of a fund are all very liquid (let’s say you can easily buy hundreds of thousands of shares of all underlying assets), a fund with 1000 shares of on-screen liquidity may have millions of shares of implied liquidity.

      So how do you find a store employee and ask them to build you a basket? Usually, a quick call to the fund advisor or to your introducing broker can point you in the right direction. They can provide you with a list and contact information for all authorized participants for ETF and give you information about the creation size and any fees associated with the creation process. Alternatively, you can create a free account on one of the RFQ (request for quotes) platforms such as Bloomberg or TradeWeb and request quotes from Authorized Participants for the number of shares you are hoping to acquire.

      What if you want to buy 5000 shares, the on-screen liquidity if only 1,000 but the creation size is 10,000? Another useful “store employee” is the lead market maker (LMM) for the fund. You can also obtain their contact information from the fund advisor and often the fund advisor will be happy to call them on your behalf. You can let them know that you want to buy 5000 shares in the market, and they will increase quote size from 1000 to 5000 to make sure you can get filled on your desired quantity.

      The same process of course also works on your way out. If you or your clients need to dispose of shares of this fund for any reason, shares of a fund with a good implied liquidity can be redeemed very quickly, efficiently, and with very little slippage.

      There are many good reasons why investors scrutinize newer or smaller funds. The ability to get in and out of position should always be viewed through the lens of implied liquidity and not just on-screen liquidity.

       

      Disclaimer

      This document does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only and on the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein, any risks associated therewith and any related legal, tax, accounting, or other material considerations. To the extent that the reader has any questions regarding the applicability of any specific issue discussed above to their specific portfolio or situation, prospective investors are encouraged to contact HTAA or consult with the professional advisor of their choosing.

      Except where otherwise indicated, the information contained in this article is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution of any future date. Recipients should not rely on this material in making any future investment decision.

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