etf liquidity explained

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2010, Morningstar, Inc. All rights reserved.

ETF Liquidity Explained

Bradley KayAssociate Director, European ETF Research

Ben JohnsonETF Strategist

September 29, 2010


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Agenda

What is liquidity?

How the ETF marketplace works

Why the biggest ETFs keep gathering more assets

Rules of thumb for ETF execution

Outlook for the future


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What Is Liquidity?

The ability to buy and sell a security without moving theprice

Factors contributing to greater liquidity

Lots of existing shareholders leads to natural buyersand sellers

General agreement on the value of the security

Ready supply of capital for market makers


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Liquidity in ETFs

Liquidity in European ETFs currently comes almostentirely from market makers who create or redeemshares at the end of day

Requires a slight spread between buy and sellprices, to compensate market makers for the costs

of hedging Market makers are paid to keep spreads at a pre-

specified level (typically below 1% or 2% for someless-liquid funds)

Since the market maker has to hedge, the liquidity ofETF portfolio holdings and ease of borrowing capitalmatter

The largest ETFs move toward liquidity coming from

existing shareholders


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How an ETF Works

ETF Provider

Market Maker

Stock ExchangeBuyer Seller

(In-kindtransfer)

ETF SharesSecurities

ETF Shares

Primary Market

SecondaryMarket

ETF Creation/RedemptionProcess


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How a Traditional Fund Works

Graphic Source: Blackrock


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Liquidity in Traditional Funds versus ETFs

Traditional funds still need to tap the capital marketseach day in order to buy and sell portfolio holdings

Not immune from the transaction costs incurred bymarket makers crucial to ETF trading

Some ability to avoid transaction costs by netting

inflows against outflows

ETFs force the purchaser or seller to bear the cost oftheir trade, while traditional funds spread it among all

existing shareholders Makes the cost of liquidity explicit

Provides the ETF shareholder with a measure ofcontrol over their transaction costs


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Why This All Matters

Intra-day liquidity allows you to see the price where youare buying and selling, rather than waiting for the end ofday

Allows you to rebalance a portfolio immediately, rather

than waiting a day or two to get out of one fund and intoanother

The creation and redemption process, and the

secondary market on the stock exchange that allows it,is the key to ETFs low costs

Only interacting with a handful of major marketmakers keeps accounting costs minimal

Pushes trading to arbitrageurs and trading firms who

can do it for the lowest cost, since they make the


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Does It Work?

The arbitrage process keeps market prices for the ETFextremely close to fair value, even as assets changerapidly

If the underlying securities in an ETF are liquid, then the

ETF will be as well under the majority of marketcircumstances

Unlike stocks, new ETF shares can be created, soprices do not get driven up substantially by assetinflows

Example: a new US ETF from entrant Schwab

Intended for retail investors, so inflows came frommany sources

Invests in large-cap US stocks, a very liquid


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Does It Work?

Source: Morningstar Direct


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Liquidity Over Time

Liquidity within all securities markets can varydrastically over time

Most visible in ETFs, since their bid/ask spreads make

the costs of trading explicit

During market crises, spreads will generally widen asmarket makers lose access to hedging capital andinvestors become less certain about fair values

The largest ETFs in the US kept a steady marketthrough the 2008-2009 crisis, sometimes providingfar more liquidity than their underlying securities


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Dangers of Illiquidity

Typically not much of a problem to buy into a less-liquidETF

May require more patience if it is not monitoredactively by market makers

May require going directly to a market maker

The loss of liquidity during a crisis tends to be steepestfor smaller and less liquid ETFs within a category, asthese are most reliant on market makers keeping an

orderly market

Not saved in a traditional fund, as they still need to sellsecurities in the vanishing market to meet shareredemptions

Costs spread among all existing shareholders


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How to Measure Liquidity

Simple approximations for liquidity More assets =more potential buyers and sellers

Greater daily volume = more flow, lower marginsdemanded

Liquid underlying = easy hedging for market makers

More precise measures of liquidity

Bid/ask spread

Depth of order book (XLM) Premium/discount

Market impact from past trades


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Bid / Ask Spreads

A large component of buying and selling costs for ETFsis the difference between the bid and the ask

Larger ETFs typically have tighter bid/ask spreads

< $5 MillionAssets

> $10 BillionAssets

Bid 25.68 106.39

Ask 26.16 106.4

Spread 1.85% 0.01%Data as of August 30th,

2010


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Bid / Ask Spreads

Liquidity costs are a crucial consideration whencomparing ETFs tracking similar or identical indices

Net

AssetsM

TER

(%)

Daily

AverageTrades

Daily

Average

TurnoverM

Sprea

d (bp) M%

Daily

AverageTrades

Daily

Average

TurnoverM

Sprea

d (bp)

Ytd%

Amundi ETFEUROSTOXX 50 (D) CD5 FP EUROSTOXX 50 1 0.15 2.77 0.02 4.73 -4.27 1.55 0.01 4.48 -Lyxor ETFEUROSTOXX 50 MSEFP EUROSTOXX 50 5,119 0.25 299.36 27.75 5.77 -4.05 395.06 41.46 5.44 -8.55EasyETFEUROSTOXX 50 B ETDFP EUROSTOXX 50 448 0.25 10.64 0.65 11.96 -4.24 19.01 1.27 13.61 -8.97HSBCEUROSTOXX 50 ETF 50EFP EUROSTOXX 50 32 0.15 5.14 1.27 15.65 -4.26 7.04 1.24 14.00 -11.85EasyETFEUROSTOXX 50 A ETEFP EUROSTOXX 50 24 0.25 1.82 0.00 22.85 -4.22 3.25 0.10 36.00 -9.27EasyETFEUROSTOXX 50 ETB FP EUROSTOXX 50 164 0.25 1.14 0.02 24.03 -6.44 3.75 0.12 37.00 -11.73

Source:NYSEEuronext, MorningstarDirect

August Ytd

Name Ticker Underlying Index


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Premiums and Discounts

Premium / Discount toNAV history

-0.20%

-0.15%

-0.10%

-0.05%

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%

iSharesRussell 2000

iSharesS&P500

Smaller fluctuations in the past = more liquidity


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Rules of Thumb for Trading

Use limit orders rather than market orders

Does not rely on a deep order book

Allows you to set a fair price for the purchase or sale

Market makers can see your order on the exchangeand fill it

Stop-loss orders tend to cause the biggest problems

Drops a market order on the exchange when pricesare going down

Tends to place a sell order precisely when liquidity islowest

Led to major losses in the May 6 Flash Crash in theUS

Circuit breakers on European exchanges will keeplosses smaller but not revent them entirel


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ETF Trade Execution Gone Wrong

ETF with nearly $1 billion in assets under management

Relatively strong liquidity in the secondary market


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ETF Trade Execution Gone Wrong

Too large of a market order for the immediate liquidity

on the exchange Market makers do not always want to post their full

order size on funds that they are not constantlymonitoring

This order executed at a variety of prices, with thepeak being 19% above fair value

After the market order went through the books, thebid immediately came back down to near the fairvalue of the ETF

Could have been avoided by using a limit order

Look at iNAV to see what fair value of the portfolio is

Bid, ask, and recent trade prices also give a goodidea of the current fair value


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Fair Value Pricing

The iNAV is not always accurate Foreign stock ETFs trade in Europe even when the underlying

markets are closed

Events can arise when local markets are closed that will impactvaluation once trading opens, but iNAV may not incorporate thatchange in value

Market makers rely on futures, local listings of foreign shares,demand changes, and proprietary algorithms to determine asecuritys fair value

If a large number of trades are occurring at fairly tight spreads,that suggests a reasonable market price even if it differs fromiNAV

Graphic Source: Vanguard


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Trading Best Practices

Use limit orders

Avoid stop-loss orders

Evaluate the market Indicative values Recent trade prices Bid / ask quotesAvoid trading during extreme volatility (Flash Crash)

Trade when the underlying market is open andfunctioning


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The Future for European ETF Liquidity

Most investors are still large, slow-trading institutions Even the highest volume ETF in Europe only trades

about 50 million per day through the exchange,less than 1/250th of the volume traded throughSPDRs (the worlds largest and most liquid ETF)

The market is still reliant on market makers andcould face some trading disruptions in another majorcrash

Liquidity is growing rapidly

Hedge funds are shifting toward using ETFs in placeofOTC derivatives from investment banks

Retail investors and advisers are starting to buy offLSE, Deutsche Brse, and Borsa Italiana


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ETF Liquidity is Growing Rapidly

Exchange YTD Trades % Change YOY YTD Turnover (M) % Change YOY

Deutsche Borse - - 107,975 33.3%

LondonStock Exchang 831,707 35.1% 67,316 47.7%

NYSEEuronext 1,406,420 4.5% 64,126 14.0%Source: Deutsche Borse, LondonStock Exchange, NYSEEuronext

Year-to-date trends through August are encouraging

Though the trend is positive, there is still a long way to

go


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The Future for European ETF Liquidity

ETFs pulling in the greatest amount of assets andputting up the largest volumes will continue to succeed

Lower trading costs mean a lower total cost ofownership

More purchasing across the European exchanges

A spread thats only one penny tighter on a 10share is worth 100 on a 10,000 trade

Biggest ETFs will keep their liquidity even during a

crash Likely to end up as one of the lowest-cost ways to

trade illiquid asset classes like fixed-income andforeign markets during a crisis


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