ETF Liquidity In Action by Noel Archard

April 12, 2012

If you know me, you know I love a good liquidity story. Watching the tape a few weeks ago, I saw what I think is a great example of liquidity in one of our newer funds and the ETF creation/redemption process in action.

Some investors tell us that seeing trading volume is important to feel comfortable buying a newly launched ETF. Understandably, they want to make sure that they’ll be able to get in and out of the fund when they want (and at the price they want).

But this recent example affirms once again that what investors see in the secondary markets isn’t the full story.

In March, we saw a very large trade in one of our newer funds, the iShares Barclays US Treasury Bond Fund (GOVT). GOVT offers access to the entire 1-30 year Treasury curve in a single trade. That particular day, an investor bought 11 million shares of GOVT ($270 million dollars worth) in one trade.

Two things are impressive (and instructive) about this trade:

First, the trade was executed in a single block with zero market impact. The trade was executed 6 cents below the last offer. That means that the investor was able to place a very large trade without incurring significant transaction costs or altering the fund’s market price.

Second, GOVT grew by 58x in a single instant. I know that looks like a typo, but it’s not. The fund was able to absorb an exponential influx of assets without a hitch. This goes back to the magic of creation/redemption – the ETF can grow and shrink because large institutional investors can “create” new shares of the fund according to demand. (For more on how that’s possible, check out this video.)

What does that mean for you? When it comes to ETFs remember that liquidity isn’t limited by what you see on the screen. Rather ETF liquidity is a function of the liquidity of underlying securities. If the underlying market is liquid, like the Treasury market in the example above, the ETF can adjust to meet demand.

For investors who have large sized trades to execute, like in the case of the GOVT example, the ETF sponsor should be able to connect them with the market participants who can provide this type of best execution.

It might be an old story, but it’s one that I never get tired of telling. Whether it’s 10,000 shares or 1 million shares or 11 million shares, the number of shares of an ETF can be increased or decreased to match current demand.

Shares of ETFs may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.