Home etftrends.com Matt Lewis: Why Advisors Shouldn’t Be Scared to Use Smaller ETFs

Matt Lewis: Why Advisors Shouldn’t Be Scared to Use Smaller ETFs

All too often, newer or smaller ETFs are stuck flying under the radar. Even if an ETF exhibits strong performance, if it has low assets or daily trading volume, it may still be left off popular trading platforms, meaning that advisors won’t be able to find and invest in it as easily.

That severely limits the choices available for advisors to meet their clients’ needs, argues Matt Lewis, vice president of American Century Investments. He points out that currently 12% of the ETFs on the market account for a whopping 90% of current trading volume in ETFs.

“Maybe that 12% are fine,” he says, “But there could be newer strategies that may have a better opportunity to meet investors’ goals.”

Recently, I spoke with Lewis to get his insight on how to evaluate the liquidity of ETFs with smaller assets under management or trading volume, as well as discuss some tips and tricks on how to trade these ETFs with ease.

Lara Crigger, Managing Editor, ETF Trends: As long as I’ve been covering ETFs, advisors and investors have used two metrics as a baseline for ETF liquidity: A fund must have $100 million in assets under management and $1 million in daily trading volume to be considered sufficiently “liquid.” How useful is that rule of thumb these days?

Matt Lewis, Vice President, American Century Investments®: By using those hard constraints for screening ETFs, investors risk missing out on a compelling strategy that may meet the investor’s goal, as well as limit their choices of which ETFs they can invest in. The focus for investors/advisors should be on the ETF strategy and if it is a fit for the investment goal, the portfolio allocation, the anticipated outcome.

More and more, I have seen a shift in investors’/advisors’ thinking about the necessity for the liquidity and assets under management (AUM) metrics to be met before investing in a product. Investors have become more comfortable trading ETFs that are smaller in both AUM and volume, understanding that the larger pool of liquidity for an ETF is with the liquidity of the underlying securities that the ETFs hold. This liquidity can be accessed through the creation and redemption mechanism. This unique mechanism also externalizes the cost associated with implementing the strategy when new investors come in. This is true for both small AUM products and large AUM products.

As I talk to advisors and investors, they seem to be more confident than in the past with trading low volume and low AUM ETFs. In these conversations, I always advise to be cautious in just using a market order to execute ETF trades —

Crigger: I’m sorry, I just got hives when you said “market order.”

Lewis: I agree with that. [laughs]  For what I see, liquidity is there for any size ETF, and there are ways for advisors and investors to access the most efficient price, even if the ETF is not at the $1 million [in average daily volume (ADV)]  mark. There’s just a couple of extra steps that ETF investors should consider.

I think it’s important that when investors and advisors see an ETF they want to own and at a price that they want to invest, they need to put some protection around that, be it by using a limit order or using block desks for large trades — even small- and medium-sized trades too. Custodial platforms have dedicated trading desks to help investors achieve efficient pricing for all types of ETFs. The beauty of those desks is that they see the market, but they also have very good direct relationships with the ETF liquidity providers, so they can go out and source the most efficient prices for specific [ETF]  trades.

Another thing that’s important for investors to know is that if you’re only considering the “super liquid” ETFs, then you’re only looking at 12% of the products out there. Those 12% of products represent 90% of the ETF trading volume. So you’re actually really limiting your scope of strategies and products that could meet the investment objectives better than those 12% out there. Maybe the 12% will do fine. But there could be newer strategies that may have a better opportunity to meet investors’ goals, and they won’t have $100 million AUM or trade $1 million each day yet. But investors can still achieve efficient prices in these smaller ETFs by taking the steps I mentioned earlier.

Crigger: So let’s back up a second and talk about the differences between a market order and a limit order.

Lewis: Market orders are trades that when they are submitted, they go directly to the market and are filled at the next available price being offered. But if your market order is larger than the size that is being offered, you’re going to get that price for the offered size, and then you’ll get a higher price maybe for the next part of your order, and then maybe even a higher price after that for the next part of the order, and so on. We don’t like to see that happen. But it does.

You can control that type of trading sequence from happening by using a limit order. A limit order is an investor saying, “I want to buy a certain number of shares, at a specific price.” That will go into the market for the liquidity providers to assess. The broker-dealers can view these limit orders very quickly, and they’ll execute the order at that price or, if available, a better price than the prevailing offer.

When buying I have observed ETF investors price a limit order a penny or two above the best offer that’s being shown. This is a good strategy, because a limit order acts as a very small speed bump to allow the liquidity providers to assess that order, grab that order, and fill it at the most efficient price. When investors employ this strategy, I have seen the orders usually get filled at the prevailing offer or, at times, even within the best offer.

Limit orders do take a little extra work. Depending on the intra-day volatility of the market, the price you see may move quickly. That will require the investor to adjust the limit order, if the order is not sent into the market before the price has moved.

Crigger: Why do you think advisors still rely heavily on market orders?

Lewis: I think it’s because [limit orders]  add an extra step. Maybe their systems don’t accommodate that extra step. Maybe they don’t have the resources to handle that extra step.

That’s why I think it’s important for advisors to get in touch with their custodial platforms and reach out to the block desks that have been set up. These desks have taken the time to develop deep relationships with the ETF liquidity providers to be able to execute ETF orders, large and small, at the most efficient price. By using a block desk, an advisor is putting the order into professional traders’ hands, who have the care, expertise, and relationships to have a smooth, efficient execution.

Time and time again, I have observed quality execution for large-, mid-, and small-size ETF trades when they are handled through an advisor’s custodial block desk.

Crigger: For advisors who may not have ever worked with a capital market desk before, where do you start that relationship? Which questions should they ask?

Lewis: Investors should know that there are capital market desks at issuers that are serious about being in the ETF space. I run the ETF capital markets team for American Century, and we spent a lot of time building relationships with ETF liquidity providers, authorized participants, as well as monitoring our products for our market quality expectations with a focus on the spreads. When we see something that falls out of line with our expectations, we’re in touch with the market participants and the ETF liquidity providers to find the reason for the intermitted dislocation. We’re here to help clients navigate the ETF ecosystem when trading ETFs, and also to monitor the appropriate behavior of our ETF markets given the market dynamics.

As for the custodial block desk, advisors should just ask their custodial representative: Do you have an ETF block desk that I can develop a relationship with, and how do I go about doing that?

From there, there will probably be questions around technology set-up, how to place a trade, if there are any size limits of ETF orders that can go through the desk, etc. Advisors that I have talked to who utilize these desks say that working with them is very easy and appreciate the resource to achieve efficient prices for their clients.

Crigger: Maybe advisors think, “Well, the trades I’m making, they’re just not big enough. I wouldn’t want to bother them.”

Lewis: Certainly, there are those thoughts. But it doesn’t hurt to get the block desk’s opinion about what they think is an appropriate size. Maybe they’re willing to take that small order and assess for the advisor whether going directly out into the market or handling the order through the block desk’s request for quote is the appropriate trading strategy.

Crigger: American Century has a number of semi-transparent active ETFs, and there’s been a lot of ink spilled about these next-gen structures. How differently does an American Century ETF trade from your garden variety fully transparent ETF?

Lewis: At the end of the day, these are ETFs and trade like all other ETFs, even though they don’t disclose their holdings daily. There are elements to semi-transparent active ETF structures that do provide transparency for ETF market makers to efficiently quote and fill orders. Some of the structures have proxy baskets that are available daily that correlate with the return of the actual holdings. Another structure has a Verified Intra-day Indicative Value, VIIV for short, that is based on the underlying holdings of the ETF. That value is printed to the [consolidated]  tape every single second of the trading session, so market makers can see that value and make their markets around that. We utilize both types of semi-transparent ETF structures, and no matter which structure, we have an intra-day value out there every second based on the underlying holdings of the ETF. Every quarter, we do release the holdings, so market participants can have a reset of what the fund holds. Some issuers, like us, provide top 10 holdings monthly on their website, so market makers can have a reset of the largest holdings of the ETF monthly.

What I’m trying to get at is that these ETFs have information out there for efficient markets to be made, and I have observed that with our products. They trade like all other ETFs. I provide the same exact advice about trading semi-transparent ETFs as I would any other ETF.

It’s been over a year since we’ve launched our semi-transparent ETFs. The liquidity providers are doing a great job, and we have great partners assessing the risk of not having the daily disclosure holdings. They’re incorporating those risks in their spreads, but trading has been very efficient, and I’ve seen small and large trades go off, with multiple market participants involved in trading them. Trade it like an ETF, because at the end of the day, that’s what it is.

Crigger: Are there some segments where liquidity matters more? Does it matter more for emerging market bonds than it does U.S. large-caps?

Lewis: At the end of the day, the basis of ETF liquidity is the liquidity of the underlying securities. Large-cap U.S. equities are very liquid, so the ETFs based on them will be very liquid, even though the ADV of the ETF might not show as being high. As mentioned, the underlying liquidity can be tapped through the creation/redemption mechanism for the ETF.

But if we look at not-so-liquid asset classes, like emerging market bonds or commodities, the pricing of those underlying markets are not as transparent, some of the underlying securities may not trade every day. ETFs tracking these types of markets might be less liquid because the underlying market is less liquid.

One last point to think of about ETF liquidity: The ETF volume that has traded is what has been traded — it’s not what could have been traded in the ETF. It’s important to remember that although the volume numbers might not be as high as some of the very liquid index products out there, there is most likely plenty of liquidity to make a trade happen due to the underlying securities’ liquidity and the ETF creation and redemption mechanism.

Crigger: So when advisors see an ETF that catches their eye that maybe doesn’t have a ton of assets or volume yet, what suggestions can you give toward evaluating the liquidity and tradability of that product?

Lewis: ETFs are tradable. ETF shares can be created, and they can be redeemed. And it goes back to the underlying liquidity of the ETF’s investment. So if you’re going into any less liquid, more exotic markets, you will see wider spreads, because the underlying has wider spreads. It costs investors more to invest in these markets, and the ETF market participants will reflect that in ETF spreads. But the ETF itself is tradable. If an investor perceives a spread of the ETF to be wider than anticipated, the question should be asked, why is that? There could be a very good reason for it, and most likely it represents the costs to access the securities or markets the ETF holds.

Volume or size of the ETF really doesn’t matter. The ETF and how it trades is really derived from the liquidity of the underlying securities.

For more news, information, and strategy, visit the Core Strategies channel.


The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.

newETFs.io respects the hard work of others and gives all credit to the remarkable folks at ETFTrends.com. This excerpt/article was pulled from their RSS feed; click here to view the original. Please note that on occasion, the RSS feed will not have the author. When this happens this site defaults the author to "News". Make no mistake, this excerpt/article was not created by newETFs.io, it was simply shared with you.