The Right Way to Assess ETFs Liquidity

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1 The Right Way to Assess ETFs Liquidity Key Facts to Bear in Mind 1. When it comes to liquidity, ETF shares are not comparable with stocks. One of the key, and widely recognized, benefits of Exchange Traded Funds (ETFs) is that they trade like stocks. When attempting to assess the liquidity of ETFs, however, some investors make the mistake of carrying that similarity too far. They assume all the indicators of a stock s liquidity also apply to ETF shares, but that s not the case. 2. Average daily trading volume isn t an indicator of an ETF s liquidity. Average daily trading volume can be a good indicator of a stock s liquidity. But that rule doesn t carry over to ETFs for one simple reason. Stock shares are finite, but ETF shares are not, as the next key point explains. 3. ETF shares can be continuously created and redeemed. Like stocks, ETFs trade on an exchange where shares can be bought and sold among investors. But that is the secondary market for ETFs. ETFs also have a primary market that exists between ETF Sponsors and Authorized Participants, where shares can be continuously created or redeemed. This fact changes the liquidity picture for ETFs and renders average daily trading volume a much less significant indicator of how easy it is to buy or sell ETF shares. (See page 2 and 3 for an overview of how the creation and redemption process works.) 4. The liquidity of the underlying securities is a better indicator of an ETF s liquidity. Given that the shares of ETFs can be continuously created and redeemed, it s the liquidity of the underlying securities in an ETF that matters most. As long as the securities an ETF owns are trading, the Authorized Participants should have no trouble keeping the ETF itself liquid. Since most ETFs invest in securities that are represented in well-known indices, liquidity for the ETFs is generally not an issue. (See page 4 for more details.) 5. The bid/ask spread will decline as natural order flow increases. The bid/ask spreads of ETFs are generally dependent on the willingness and ability of ETF marketmaking specialists to create a market for the funds. As the trading volume in the secondary market of an ETF increases, a more natural order flow will develop on both the bid and ask price. The more investors there are making transactions in the ETF, the closer the highest price offered to buy and the lowest price offered to sell will likely be. Additionally, as the markets for an ETF become more efficient, it is less dependent on intervention from Authorized Participants and market makers to keep it liquid. If that happens, the bid/ask spread can decline significantly because costs previously incurred by Authorized Participants to create or redeem shares and to borrow securities decline and are not passed on to investors. (See page 5 for more on ETF s bid/ask spreads.) Not FDIC Insured May Lose Value Not Bank Guaranteed

2 OppenheimerFunds Exhibit 1: The ETF Creation Process When ETFs Are Introduced and When Additional Shares Are Created Two key participants involved: ETF Sponsor Authorized Participant (AP) The ETF Sponsor is the company or financial institution that creates and administers an exchange-traded fund. The Authorized Participant (AP) is an entity chosen by an ETF Sponsor to obtain the underlying assets needed to create an ETF. Step 1: The ETF Sponsor enters an agreement with an AP. The AP is empowered to create or redeem ETF shares with the ETF Sponsor. ETF Sponsor Authorized Participant Step 2: The AP assembles a basket of securities that was specified by the ETF Sponsor. The AP does so by either borrowing or purchasing those securities from the capital markets. Basket of Securities Exchange AP Step 3: ETF Sponsor + ETF Creation Units Basket of Securities AP The AP deposits the basket of securities with the ETF Sponsor and in exchange the Sponsor issues creation units to the AP. The transaction is considered an in-kind transaction (securities are traded for securities) and there are no tax implications. This is a major benefit of the ETF structure. Step 4: $ The AP keeps the block of shares in its own name or breaks it up and sells individual shares to investors in the open market. Investors in this secondary market buy and sell the shares among each other. Investors AP 2

3 The Right Way to Invest Exhibit 2: The ETF Redemption Process Restoring Balance When Supply Exceeds Demand Step 1: Sellers ETF Supply Demand Buyers If there is a supply/demand imbalance in ETF shares because there are more sellers than buyers in the secondary market, the AP will buy shares from investors in the secondary market. Because of the AP s presence, investors generally won t have any trouble exiting their positions when the number of investors selling ETF shares exceeds the number of investors buying. Step 2: Redemption Once the AP has 50,000 shares of the ETF which constitutes a creation unit of the ETF the AP will redeem that unit with the ETF Sponsor. In return, the AP will receive the underlying securities that made up that unit of the ETF. Basket of Securities The AP can sell those securities in the markets where they trade. AP + ETF Creation Units ETF Sponsor Step 3: Sellers ETF Supply Demand Buyers The process of redeeming shares will reduce the supply of ETF shares in the secondary market, bringing the supply and demand for shares back into balance. The fact that APs can redeem ETF shares explains why the trading volume of an ETF is not an important indicator of its overall liquidity. 3

4 OppenheimerFunds The Liquidity of ETFs Comes from the Liquidity of Their Underlying Securities As long as the underlying securities of the ETF are trading, the creation/redemption process will function appropriately. As Exhibit 3 shows, trading volume is very high for the securities that are in the large-cap (S&P 500), mid-cap (Russell Midcap) and small-cap (Russell 2000) stock indices. By comparison, the volume of trading in the largest ETF that invests in each of these indices is low. If investors were to assess an ETF s liquidity on the basis of its trading volume, rather than the trading volume of the underlying securities, they would be greatly underestimating the real liquidity of the ETF. Exhibit 3: Securities in the Large-, Mid- and Small-Cap Indices Trade at a Much Higher Volume than the ETFs that Own Them S&P 500 Russell Midcap Russell Millions Millions Millions of Largest ETF of Underlying Basket 0 of Largest ETF of Underlying Basket 0 of Largest ETF of Underlying Basket Source: Bloomberg, One Cautionary Note: Unanticipated Market Closes Have an Impact It is important to acknowledge that the creation/ redemption process requires price discovery in the secondary market. If the secondary market ceases trading, then the Authorized Participants or arbitrageurs will not know the extent of the supply/ demand imbalance. This is what happened on August 24, 2015, when the stock exchanges halted trading for a brief period. Because the APs did not know the price of the underlying securities, they were unable to correct the supply/demand imbalances in markets. Prices of the ETFs declined as investors kept selling and APs were unable to determine the discount between the price of the ETF and the value of the underlying securities. The situation corrected itself as soon as the markets began trading again, and APs took advantage of the deep discounts between the trading price of the ETFs and the real value of the underlying securities. All equity ETFs were affected by the halt in trading on August 24, including the most widely transacted ETFs in the secondary market. The stock exchanges understand the issue and are working on ways to fix it. 4

5 The Right Way to Invest For ETFs, a Wider Bid/Ask Spread Isn t Necessarily a Red Flag In addition to their NAV, which is the value of their underlying securities, an ETF will trade in the secondary market at both a bid and an ask price. The bid is the price that buyers are willing to pay for ETF shares. The ask is the price that sellers are willing to accept for their ETF shares. The bid/ask spread is the difference between the two. Investors may assume that if an ETF has a wide bid/ask spread it may be illiquid. That may be the case for stocks, but here again it may be wrong to assume the rules of stocks also apply to ETFs. To accurately interpret the implications of a wide ETF spread, it is important to understand the factors that can influence the bid/ask spread of an ETF: The trading volume in the secondary market. As trading volumes in the secondary market for an ETF increase, there will be a more natural order flow on each side of the bid and ask. The more investors there are transacting, the closer the highest price offered to buy and the lowest price offered to sell are likely to be. The spread between the bid and ask price of the underlying securities. If an ETF holds securities esoteric or thinly traded markets, the bid/ask spreads on the securities may be wider than those in more liquid markets, and that will influence the spread on the ETF. The cost of hedging investment exposure. Market makers might hold direct long or short positions in the ETFs they deal in, but to minimize their own risks, they ll often hedge their positions using derivatives, or by buying or selling baskets of the securities that underlie the ETF. The cost of creating or redeeming shares. Typically, Authorized Participants, when redeeming ETF shares with an ETF Sponsor, must redeem one creation unit of the ETF, which constitutes 50,000 shares. If trading volume on the ETF is low, it may take some time for the AP to build a position of 50,000 shares. As they do so, they may hedge away the market risk that could arise from prices fluctuating during the time they are building that position. The costs associated with that hedging will be passed on to investors in the form of a higher bid/ask spread. Size of an ETF and Its Trading Volume Can Affect Its Bid/Ask Spread As the trading volume for an ETF increases, the efficiency with which an ETF trades can improve to the point that there is less need for Authorized Participants and other market makers to intervene to enhance the liquidity of the ETF. When that happens, the bid/ask spread will generally decline. From 2010 to 2014, we saw this exact scenario play out with the largest ETF that tracks U.S. large-cap stocks. As trading volume in this ETF increased and the size of the ETF itself grew its bid/ask spread declined. As Exhibit 4 shows, in 2010 this ETF had an average bid/ask spread of four cents. As the ETF grew and its shares became more widely transacted, the market for this ETF became highly efficient and its bid/ask spread fell to one cent. Exhibit 4: The Bid/Ask Spread of the Largest ETF Narrowed Considerably as It Grew in Assets and Its Trading Volume Increased Average Bid/Ask Spread Largest ETF Tracking S&P 500 $ Source: Bloomberg,

6 OppenheimerFunds Strategies to Consider When Trading ETFs 1. Use limit orders (buying or selling ETF shares at a specified price), rather than market orders (direction to buy or sell immediately at the prevailing price available), when entering a trade to buy or sell. 2. Place orders at a fair price that you expect can be executed. 3. If you re unsure the price being offered is a fair price to be executed at, one solution is to check the intraday indicative value (inav) of the index the ETF tracks. This can be found at any data vendor (Google Finance, Yahoo Finance, and similar sites) by typing.iv after the ticker of any ETF. 5. Avoid, or at least be cautious, with stop-loss orders. 6. For orders over 3,000 shares, reach out to your trading partner for assistance. This could be an internal trading desk, an external trading firm, or the ETF provider directly. 7. Avoid trading within the first 15 minutes and the last 15 minutes of the day. ETFs are derivative securities. They derive their price from the stocks or bonds they track. Market makers often need some time after the market opens to give their most competitive prices. 4. If possible, trade during the hours that the underlying securities are trading, particularly in the case of international ETFs. Conclusion: Like a Stock, But Not Quite: An ETF s Liquidity Must Be Assessed Differently 1. While ETFs trade like a stock, their liquidity can t be evaluated with the same measurements investors use to evaluate stocks. 2. The fact that ETF shares are not finite and can always be created or redeemed changes the liquidity picture for ETFs. 3. An ETF s liquidity is driven more by the liquidity of the underlying securities, two indicators that investors use to evaluate stocks liquidity average daily trading volume and the width of bid/ask spreads may not be relevant indicators of how easy it will be to sell or buy shares of an ETF. 6

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8 To learn more about the liquidity of ETFs, please reference our short video ETF Liquidity The Redemption and Creation Process on oppenheimerfunds.com. Visit Us oppenheimerfunds.com Call Us Follow Us Investment in an ETF is subject to investment risk and the possible loss of principal. These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are subject to change based on subsequent developments. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting oppenheimerfunds.com or calling CALL OPP ( ). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. 225 Liberty Street, New York, NY OppenheimerFunds Distributor, Inc. All rights reserved. IM March 17, 2016