Liquidity | Portfolio Yoga

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

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.

Markets at near all time highs and the euphoria of a further rise in case NDA comes to power (with a massive majority to boot) has meant that retail is starting to enter in a small way. But since most of the big guns have already become too expensive (in terms of price of shares mostly though for many valuations are a stretch at the current juncture), its a season for those stocks which barely saw any trade for hours together to now be the ones much talked about.

Most of these stocks which lay theoretically dead are now roaming around like zombies though from afar, they do seem like normal behavior and hence easy to mistake one for the other.

The problem in most of these stocks is not in getting in as much as getting out. Right now, its time to get out of many such stocks as volumes have suddenly sprung up on the back of pretty good increase in price.

Warren Buffett says and I quote

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

While it makes sense logically, the problem comes in terms of practical suitability of it especially in a market where stocks go out of favor before you know. Add to that, while its true that good stocks are better held for the real long term, our life requirements mean that if for any reason we want to exit a stock, we should be able to do it without having to take massive slippage costs.

Liquidity should be the corner stone of investments in companies where you do not have a meaningful stake and one which you regard as something that could be en-cashed during times of distress. After all, what is the point in having stock worth lakhs if it cannot help you when you need it most.

The thought on the above subject came to me after reading a recommendation by a fellow blogger who has recently recommended a stock that this year alone has gone up by >80%. The problem is not in terms of the rise in itself, as a technical guy, I believe that momentum begets momentum. The concern for me in that stock (other than seeming to be expensive compared to its peers) is that this stock was having a average 10 day trading volume of <3000 for better part of last year (with there being times when it dropped below the 1000 mark as well) and now does a good 25K odd shares.

If and that is a big If, market loses flavor for the stock (in other words, operator having done his deed decides that there is nothing more to squeeze it from), its a matter of time before the stock not only goes back to square one or thereof but also for a investor who has entered the stock at higher levels, getting rid of it becomes even tougher as volumes slip back to the normal levels.

Due to changes in my own belief and trading style, I had disposed off most of my portfolio last year (and despite the massive run markets have seen, my stocks have not participated which has meant that I have been better off without then than with them) but had to hold on to a couple of stocks that were listed on BSE and were in the Periodic Call Auction list. Try as I might, I could not get rid of it ( with avg volume being less than 100 per day on many days).

Recently when I checked out the price, I was astonished to see that not only the price had nearly doubled from where I had first intended to sell but volumes have been much better too. While the strong move did have me thinking of the best possible action, knowing how tough it was to sell the same last year at half the current price, I decided the best way was to exit regardless of whether this will be a case of missed opportunity in case the stock continues to move higher.

The road to hell is paved with good intentions. Just be careful on what road you choose since when it comes to the crunch being on the highway is much preferable to being on a inside road which most of the time ends in a dead end 🙂

Tag: Liquidity

Liquidity, Spread and ETF

Buying ill-liquid Stocks

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