What's the difference between an ETF's trading volume and implied liquidity?

Franklin Templeton ETF distribution head says it's big when you trade

What's the difference between an ETF's trading volume and implied liquidity?

Advisors trading exchange-traded funds (ETFs) need to learn that trading volume does not equal liquidity, Bobby Eng, Franklin Templeton Canada’s Head of Platform and Institutional ETF Distribution told Wealth Professional.

“One of the biggest misconceptions when it comes to ETFs is the whole concept of liquidity,” he said, noting he often sees this with the institutional investors, such as large pension plans, asset managers, and investment advisors he deals with. “When you look at liquidity, the average person will look at the average daily volume, which is how many shares have been traded over the past 90 days. It could be several hundreds, thousands, or millions of shares depending on the fund.”

Eng said that’s not the ETF’s true liquidity, which is the underlying holdings that can be traded at any size. The ETF is at least as liquid as the underlying securities. The true liquidity is actually the implied liquidity.

“This is a big misconception in the marketplace. People typically will just look at the number of shares and, if it’s not an adequate number – whatever that number may be for either the advisor or institutional investor – they’ll simply disregard it or have a concern about it,” he said, noting implied liquidity really looks at how many shares can be traded without impacting the market. “The true liquidity of an ETF is the implied liquidity. So, that looks at a future number as opposed to a historical number of how many shares can be traded going forward.”

“I would caution investors not to forego ETFs that possibly have lower average daily volume because that simply does not mean you can trade it,” said Eng, noting that institutional investors can trade big blocks without any market impact. He said it was especially relative when they are evaluating two ETFs.

“The ETF with the lower average daily volume may actually have a lower management fee. So, you’re missing out on a cheaper, less expensive vehicle, because of lack of education,” he said.

Eng said Bloomberg created the implied liquidity feature and statistic and it’s available there, but those who don’t have access to Bloomberg don’t have the statistic. If that’s the case, advisors can work with their ETF provider, who can provide the statistic and help them with the trade execution so they can experience what he’s teaching.

“Once they learn that, this is great. They can actually go ahead and trade a good size. Their comfort level increases significantly because they have actually experienced it themselves and they’ll be able to trade an ETF they might have disregarded or forgotten because it didn’t meet a certain criteria,” he said. “But, that’s certainly not the way we look at it because you’re basically forgoing a very viable and possibly a lower cost ETF because of lack of knowledge. That’s my job, and the job people in the ETF industry: to educate the marketplace about this.”