Liquidity, Spread and ETF

While the Asset under Management Exchange Traded funds are a tiny sum compared to the amount Mutual funds have been able to mobilize, they are slowly but surely growing despite it being a product that neither the producer takes interest in selling nor the distributor (stock broker in this instance).

Unlike a Mutual fund where funds charge a trailing commission (non direct) of upto ( and a few even above) 300 basis points per year, most ETF’s have a expense ratio of 50 basis points or less. When it comes to returns, they being passive investments currently hog the middle band when compared with Mutual funds of the same class.

But the biggest issue facing ETF’s to me is the issue of Liquidity and Spreads. Rather than try to explain the meaning, let me post a picture of the definition (plus a tongue in cheek remark) from the book, The Devil’s Financial Dictionary by Jason Zweig

A key way to understand liquidity is by comparing a asset such as Stock / Mutual Fund / ETF vs a asset such as Land. Selling a piece of paper is way easy than selling a piece of land. No wonder that holding period of stocks are low while holding period of land is pretty high.

Spread on the other hand is the cost that will accrue to you to do the deed. Once again, unless markets are in turmoil, you should be able to sell your stock without suffering large slippage. In case of Mutual Funds, its the headache of the fund manager since he is obliged to give you the NAV regardless of how liquid his portfolio is.

ETF’s in many ways behave like stocks since unless you are a big investor, you will ideally be buying and selling it in the stock exchange rather than dealing with the fund house behind the ETF. But how liquid are ETF’s in the first place?

Following is a list of 12 ETF’s that track Nifty 50 and were traded today, a day of pretty low volatility and no panic by either the buyer or seller.

In the table, check out the dates. Do you notice that not all dates are that of 11th May 2016? LIC ETF did not trade a single unit today while Edelweiss ETF has not traded for 2 days now (database I am using is updated till y’day, but if you were to check today’s trading data, you shall see that no trades took place today either).

So, how does it impact you as a investor?

Rather than assume the worst (exiting say the Edelweiss ETF – Nifty 50), lets assume you wanted to Buy SBI-ETF Nifty 50 which thanks to investment by EPFO has a sizable AUM of 6,400 Crores. On the NSE, you shall find the spread as shown in the pic

SBI ETF Order Book

As you can see, there is real limited liquidity despite it being just 1 / 100 of Nifty (Nifty Bees for instance is 1 / 10 while Edel is 1 / 1). In fact, if you wanted say 500 units, you will need to buy at 81 and for 1000, you may have to buy at 83.

You may think that like in stocks, a rupee or two should hardly make a difference. But you couldn’t be more wrong for every Rupee in this ETF equals 100 points in Nifty. In other words, if you were to buy at 81, you are essentially buying Nifty at 8100 (vs Spot Price close of 7900 and NAV of 7948 (79.48). In other words, just to get in, you may have to pay a premium that is more than what its worth.

And this on a calm day like today. Just think of wanting to exit when the markets are in turmoil with Nifty having fallen > 3% (lets not even bother with bigger numbers). I guess, you can think of how much a impact such a move will make in terms of your returns.

Liquidity begets Liquidity and the same couldn’t be more truer in the above case. I personally use only Nifty Bees and despite it being the most liquid of the choices we have, you can still have a pretty big slippage if you want to buy or sell in a volatile market.

The advantages of ETF are many, but let it not blind you to the risks they carry. Liquidity is the biggest risk as a ETF investor and the spread can seriously affect your returns even if you are using this not for trading but for investing.

Do note that I have no affiliation with any ETF / Mutual Fund house. Above views is just for sake of helping you make the right decisions by providing you with the right perspective of how to look at things.