Does ETF liquidity matter for investors?

The Indian asset and wealth management industry laments the lack of liquidity in ETFs, encouraging investors to buy passive funds instead. But what is liquidity and does it matter?

In the past few days, two papers have been issued to answer this.

The CFA Society India issued a report on ETFs generally with some recommendations to enhance liquidity

A Report on the Indian Exchange Traded Funds (ETF) Industry by CFA Society India

Anubhav Srivastava, of Infinity Alternatives and an ETF expert,  issued a primer on ETF liquidity

ETF Liquidity and Index Funds Primer

MMI’s founder, Hansi Mehrotra, arranged a panel discussion through the CFA Society India to discuss both these points of view. The panel discussion was webcast live on 1 June 2020.

The key points discussed –

How ETF liquidity is defined

Mehrotra raised the question of what the industry is referring to the lack of liquidity. She highlighted that the CFA Society India paper, as well as many global and local commentators, refer to the lack of liquidity mentioning a number of different aspects such as –

  • Low average daily turnover volumes for ETFs
  • High bid-ask spreads
  • High impact costs
  • High tracking error

The panel discussed the issue though didn’t settle on one particular definition.

Mehrotra shared a couple of tables showing tracking error and impact costs of ETFs tracking the Nifty 50 and Nifty next 50 indices.

Possible causes for the lack of ETF liquidity

The CFA Society paper had raised a number of possible reasons for the various measures of liquidity. These included –

India’s market structure

  • Average daily trading volumes of ETFs vs stocks
  • Role of Authorised Participants (AP) and Market Makers (MM)
  • Trading & settlement?
  • Securities lending & borrowing
  • Futures & options

India’s market practices

As an example of market practices, the CFA paper had highlighted an anomaly in the Indian ETF market compared to global practices – in India, any investor can approach the ETF issuer to create and redeem baskets while globally only Authorised Participants (APs) are allowed to do so. Ramachandran posited that this market practice takes away the liquidity from the stock exchange.

Ramachandran has also mentioned SEBI’s diversification guidelines in the paper as a possible issue though Srivastava and Jain said these were ok.

Srivastava was of the view, in the discussion and in his paper, that ETFs derive liquidity from the underlying stocks, hence there was no merit in discussing the lack of liquidity as an issue.

Srivastava added that the issuers not publishing iNAVs and eNAVs on a continual basis could also be adding to the perception issue.

Technology and education are the answer

The discussion turned to possible solutions to the perceived issue. Srivastava mentioned that the availability of technology platforms such as WealthDesk helps with building a portfolio of ETFs that investors can buy and manage better. His firm, Infinity Alternatives, now provides such a service called Aver.

Mehrotra asked the panelists if the ETFs are charged the 2 basis points fee for investor education which meant that passive investors were paying for the education of active investors. Jain confirmed they do and that were plans afoot to spend that charge on investor awareness of ETFs. Similarly, investor education initiatives such as The Money Hans are raising awareness about ETFs.

Conclusion

Overall, the panel concluded that the perception of lack of liquidity in ETFs was overblown and that it is not an issue for retail investors. They agreed that retail investors could indeed consider portfolios of ETFs for their needs.

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