Best Practices for Trading Less-Than-Liquid ETFs

Scott Burns: Best practices for trading less-than-liquid ETFs.

Hi, there. I'm Scott Burns, Morningstar's director of ETF research. Joining me today is Leland Clemons. Leland is a managing director with iShares overseeing their U.S. capital markets desk.

Leland, thanks for being here.

Leland Clemons: Thanks for having me, Scott.

Burns: So, one of the issues that a lot of investors get when they first move to ETFs, especially if they're coming from more of a historical mutual fund base, is dealing with the ET part of ETF, that exchange-traded part. And there are a lot of questions and concerns out there that not all ETFs are as liquid as some others that are there out there. I think your firm, iShares, has a very unique position; you've got some of the most liquid securities on the entire planet, but you've got a very broad product line that's out there, and not all products are as liquid as, say, your emerging market ETF.

When we look at some of those less-than-liquid ETFs, how do you help investors get comfort that it's OK to still invest and trade? What are some of the things they should look for?

Clemons: So, the first thing we try and do is help investors understand that trading volume does not necessarily equal liquidity, which is the exact opposite of what anyone who's been buying stocks is conditioned to think, but once you remember that ETFs are a portfolio of securities, we try to get folks to understand that the liquidity that you can achieve is bound by the liquidity of those underlying portfolio securities, not necessarily the trading volume that may be advertised on, whether it's Bloomberg, Reuters, or Yahoo Finance…

Burns: Or maybe Morningstar.

Clemons: Or Morningstar.

Burns: Thanks.

Clemons: ... But it's a real challenge for people because of what they've been trained to think through as the defining characteristic of liquidity. Our job is to make sure that clients are looking at the full spectrum of products. So, whether that's the 233 iShares or the over 1,000 ETFs that exist in the ETF universe, look for the exposure you want, and then you should be working with sponsors or other providers to help you understand how to get the liquidity you need, which is often going to be leveraging marketable limit orders to find that liquidity or flush that liquidity out that's in the underlying portfolio.

I said a mouthful, but it comes down to calls that are pretty simple, whether we are talking with institutions or financial advisors, we take calls at the capital markets desk every day with clients saying, "Hey, where should I, how should I, place an order to buy 500 shares or 5,000 shares?"

Burns: So where could somebody, whether a retail investor, an advisor, one-off, can they just reach out directly to your capital markets desk? Where would they find that number?

Clemons: Absolutely, so on iShares.com, I think, we have got the number publicized and then…

Burns: So it's not a secret. I think that's something, you know, people think ... people are reluctant. But your team is set up to answer those questions.

Clemons: We absolutely are, and then we also have 1-800-iShares, which is great way for clients to find any resources available within the organization. So, we'll take calls from, a lot of times, the folks answering the 1-800-iShares number. And like I say, clients will often ask us, again large institutions and smaller advisors, "What's the trade size at which I should be calling you?" And the answer is, when you feel uncomfortable about the trade you are about to place.

Burns: Right.

Clemons: If you are an institution placing a 5 million share order in something that trades 500,000 shares a day, you may be uncomfortable.

Burns: You should be.

Clemons: If you are an advisor placing a 5,000 share order in something that trades 500 shares a day, same concerns.

Burns: Right.

Clemons: They are often mitigated with simple tools, like using marketable limit orders to identify the liquidity of the underlying portfolio. We recognize we have tools at our disposal that afford us the ability to find that liquidity point more so than the average advisor, which is why we take the calls.

Burns: So I think it's a bit of a mystery to people as to how ... if I'm an advisor and I've got that 5,000 share order on something that trades 500 shares on average a day, how can I possibly get good execution on that. It just seems so counterintuitive. So how is that possible?

Clemons: The big difference in how you achieve finding this sort of hidden liquidity in an ETF versus a single stock is remembering that ETFs are open-ended vehicles, so authorized participants or broker dealers can create new shares or new inventory, when they are supplying buy-side clients with ... meeting that demand.

So, what they'll do is essentially at the point where they can purchase the underlying securities, ... so let's say, an ETF is, the bid is $25 and the offer is $25.05, so you've have a $0.05 spread, but at $25.07, as a broker dealer, I can create all the shares I want, by essentially purchasing the underlying portfolio securities in their appropriate weights. At $25.07, I'll sell you as many shares as you want.

Because I can create more inventory, that's my cost. Clients need to understand that they're open-ended vehicles, and that new inventory can come to market when there is demand. Finding where that $25.07 is, is the challenge. We recognize that there are some technological constraints and just to be quite honest, costs of data. We have that information at our disposal, and thus we can use that to help clients identify the points at when they can get their trade done.

Burns: So I think that's something we'd definitely recommend to investors of all sizes. If you feel, to your point, uncomfortable, give your folks at the capital markets desk a call.

To be fair, I think most of the ETF providers have done a great job building out similar capital markets, so on a broader basis, that's available. And I also get the sense that a lot of the platforms now, whether it's the discount brokerage or the advisor platforms, have really put more emphasis on their ability to provide liquidity, would you agree with that?

Clemons: Absolutely, so we've been working with a number of the discount brokers and intermediaries for years on the systems that they can access, how to think about ETF liquidity provision, and how to have a straight conversation with clients when they call, so that you're speaking sort of consistent investor language, as opposed to throwing around a lot of the ETF terminology that we've all invented over the last 10 years--which is, to be candid, part of the problem, is that we're sort of speaking apples and oranges with the clients. So, we've got to do better at that as an industry, to sort of straight talk with clients.

But once you get the basics down about how ETF liquidity can be provided beyond, I think, single stock perceptions, most clients have really positive experiences and find that the landscape of product available to them really opens up. So, instead of thinking about for large cap, there's only one product available or two products available, there are actually close to hundreds that you can choose from. So, you can get very targeted in the exposure you want without thinking of liquidity as a hurdle.

Burns: Leland, thanks for stopping by. I think that's a lot of great advice for people. I think, in terms of making sure that they have a good investment experience from not doing something adverse, to also, again, opening up that available product spectrum that's there to them. So, thank you for stopping by.

Clemons: You bet.

Burns: I'm Scott Burns with Morningstar. For this and other ETF information, please check out Morningstar.com's ETF Center and Morningstar's ETFInvestor newsletter.