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Sizing Up Liquidity in ETFs

Scott Burns

Scott Burns: ETF portfolio tips from the pros.

Hi, there. I am Scott Burns, Morningstar's director of ETF research, coming to you live from Morningstar's premiere ETF Invest Conference.

Joining me today is Michael Iachini, who is a director in Charles Schwab's Investment Advisory business. There Michael oversees a team of analysts that are responsible for selecting and evaluating mutual funds for and ETFs for Schwab Select List and also for their internal model portfolios.

Michael, thanks for joining me.

Michael Iachini: Thanks, Scott.

Burns: So Michael, when advisors are looking for ETFs out there, what is the one thing that right now you think is the most critical missing element in their due diligence process?

Iachini: Well, I think a lot of advisors do a good job on the basics. They will certainly think about what's the cost, the ongoing operating expense ratio of an ETF, and that's good. But a lot of advisors think about liquidity of the ETF in the wrong way. They know they have to be able to trade it and they know they don't want to have high trading cost for their clients, but sometimes advisors might be tempted just to look at the trading volume of the ETF on the exchanges. And really, if you want to understand how liquid an ETF is, you have to consider the liquidity of the underlying stocks or bonds inside the portfolio, and I think some advisors don't go quite far enough in really understanding that liquidity.

Burns: When you guys are evaluating that, when it comes to liquidity, do you have any thresholds or breakpoints that you are using right now to kind of help determine, or at least good rules of thumb that you would give advisors who don't maybe have access to the kind of data and tools that professionals are using?

Iachini: Sure, yes. When it comes to just looking at the ETF's own volume, we do tend to focus on dollar volume rather than just the share volume, and a good rule of thumb is you want to see at least $1 million a day of volume for the ETF that you are trading.

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But when it comes to the underlying part of the liquidity, there it's more of a comparative thing. So if you are considering a couple of different ETFs that are in the same asset class, maybe a couple of high-yield bond ETFs or a couple of emerging market stock ETFs, you have to take a look at how the manager actually manages the portfolio and how diversified is that portfolio.

The more holdings in the portfolio, the more different bonds they have, the smaller some of those bonds might get at the bottom, the more difficult it might be for those authorized participants on the exchange who help facilitate the trading of the ETF, the tougher it might be for them to effectively trade the underlying securities, and that could hurt the ETF's liquidity.

Burns: Right. Although with so many of the ETFs out there, there is the structural advantages, like the Vanguard structure where the holdings and the creation baskets are two totally different things?

Iachini: That does happen in some funds, and if the manager handles that smartly, they could actually help enhance the liquidity by saying, well, here are the securities that we want in the creation basket, a little bit different in the redemption basket and that might help the ETF trade more smoothly.

Burns: Right. So in your portfolio construction these days, what's the newest kind of ETF or asset class that you guys have added to your strategy?

Iachini: Well, something it's a little bit new for us with our model portfolios this year is commodities. Previously, we hadn't specifically carved out a piece of the portfolio for that, but as we have done more research into asset allocation, we have decided that for most investors it does make sense to have a small allocation, maybe 5% of the portfolio or so, to the commodities asset class, mainly because it doesn't move in lockstep with the rest of your portfolio.

Burns: Now, with all the hubbub that's going around right now given ETFs, and it really it's ETFs or index funds or privately managed funds, using that rolling futures contract strategy, are you guys employing commodity exchange traded products that use that strategy or if you've really just gone physical?

Iachini: We have a mixture. We do have some ETFs that use the physical commodity itself, so that completely avoids the rolling problem. And when we do have commodity ETFs that use futures contracts, we'd like the funds that have some choice to pick the futures contract that has the best yield in the future. So rather than being locked into just the next futures contract one month out or two months out, they can take a look at the futures yield curve and say, okay, which part of the curve gives us the best return for our clients, and invest in that contract. We like that structure.

Burns: Yes. So that's some of the PowerShares, Deutsche Bank products, and then some are even the newer products, like that GSCI product that just came out recently.

So the ETF industry, I think, they have recognized there is a problem and are trying to evolve their way around some of those issues.

You guys do some tactical tilting in your portfolios. Right now what is your biggest overweight and your biggest underweight in your portfolios?

Iachini: Well, right now, one of the overweights we have in place is to China. We do like the growth story in China, and we have overweights of both China large-cap and small-cap stocks. And essentially, the way we manage our portfolios, any time we overweight something, we are going to underweight something else in the same asset class.

So we are not swinging from stocks to cash and back and forth. So right now, with the China overweight, we are underweighting the rest of our developed market stocks internationally.

Burns: Okay. And there are actually a lot of variety in Chinese ETFs out there. Some hold ADRs, some are Hong Kong or H-shares and ADRs, some are just H-shares. What is your preferred vehicle right now to access China, given, I think, that we are looking at 18 Chinese ETFs right now?

Iachini: Yes. We like diversification and we like liquidity. So when it comes to picking the ETF, there are a lot of choices, you can go a lot of different ways. But what we really want to have is the broadest possible representation as long as the ETF still needs our liquidity thresholds, and we do care about cost as well, we like to keep cost low.

Burns: All right. Great. Well, Michael, thanks for taking the time to be with us today.

Iachini: My pleasure, Scott.

Burns: And I'm Scott Burns with Morningstar. Thank you.