Understanding ETF Implied Liquidity

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Includes: DXJF
by: WisdomTree

By Paige Corbin

This blog post is relevant to institutional investors interested in trading exchange-traded funds (ETFs) in significant volume. Individual investors do not always have access to liquidity providers to trade ETFs as referenced below.

The saying "Don't judge a book by its cover" can be applied to ETFs when discussing trading volume and liquidity. Oftentimes investors will rule out ETFs because they don't meet a certain average daily volume (ADV) threshold. This could eliminate from consideration hundreds of ETFs that could potentially be effective and impactful investment vehicles.

Let's take a look at the ADV of all the U.S.-listed ETFs. As you can see in figure 1, more than half of the U.S.-listed ETFs in 2015 traded fewer than 50,000 shares a day, and only 151 funds traded more than 1 million shares. Many investors use 1 million shares as a volume threshold when surveying investment opportunities. By doing so, they are missing out on more than 90% of ETFs available.

Figure 1: Number of Funds By Trading Volume Bucket
Click to enlarge

Introducing ETF Implied Liquidity

ETFs are at least as liquid as their underlying basket, and there is a more accurate way for them to be measured than by the average daily volume of the ETF wrapper itself. ETF Implied Liquidity first looks at how many shares of each underlying component are in a creation unit. The final output assumes that if transacting in the underlying securities, how many ETF shares would that translate into while being no more than 25% of the 30-day average volume of any security in the basket. ETF Implied Liquidity is a conservative measure of what can potentially be traded in ETF terms based on the ETF's components, whereas average daily volume is historical.

In order to effectively demonstrate the importance of implied liquidity, we can take a look at the WisdomTree Japan Hedged Financials Fund (NYSEARCA:DXJF). The 30-day average volume was 18,400 shares (as of December 16, 2015, per Bloomberg). If we judge this ETF solely by the average daily volume, it may get overlooked despite the fact that as of December 16, 2015, it had returned 11.64% since the beginning of 2015, and 27.37% since inception. But its implied liquidity for the same day was 1.6 million shares. That's a stark difference-18,400 shares versus 1,600,000 shares-especially in regards to evaluating the liquidity of an ETF. If investors can understand that the liquidity of an ETF lies in the components of the underlying basket, they can expand the realm of investment choices.

Trading Large Blocks of Low-Volume ETFs

In addition to liquidity misperception, many investors are worried about price impact on the ETF for a large trade size. Let's continue looking at DXJF as an example to see how large trade size can be executed without impacting the Fund. In figure 2 we see that on November 5, 2015, a 61,062-share block traded on the offer. That is more than three times the average daily volume! The client who initiated this trade was able to work with an ETF liquidity provider who had the ability to access other sources of liquidity to facilitate the block trade of 61,062 shares. ETFs with lower ADV typically execute in large size with minimal market impact through liquidity provider facilitation. This is the power of implied liquidity.

Figure 2: DXJF Trades on 11/5/15
DXJF Trades

Due to the importance of implied liquidity with regards to ETF selection and tradability, WisdomTree will begin making ETF Implied Liquidity information available daily on our website for all of our equity Funds.

We do not want investors missing out on an investment opportunity because information was not widely disseminated outside of Bloomberg terminals previously. We want ETF investors to understand that the liquidity is available, and the 30-day average volume is not necessarily a true representation of the liquidity profile of an ETF. We hope that by providing this information, we are empowering investors and giving them the tools to make the best investment decisions.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Funds focusing their investments on certain sectors increase their vulnerability to any single economic, regulatory or sector-specific development. This may result in greater share price volatility. The Fund focuses its investments in Japan, thereby increasing the impact of events and developments in Japan that can adversely affect performance. The Fund uses various strategies to attempt to minimize the impact of changes in the Japanese yen against the U.S. dollar, which may not be successful. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. As this Fund can have a high concentration in some issuers, the Fund can be adversely impacted by changes affecting those issuers. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund's prospectus for specific details regarding the Fund's risk profile.

Paige Corbin

Paige Corbin, Capital Markets Associate

Paige Corbin is a member of the Capital Markets team based in New York. The Capital Markets group is involved in all aspects of WisdomTree ETFs, including product development, seeding and bringing new products to market and working with the investor base on trading and best execution strategies. Paige also supports the trading community on providing liquidity and works closely with Hedge Funds and RIAs on trading and investing in WisdomTree ETFs. Paige began her career in finance at Bloomberg LP and subsequently at Bloomberg Tradebook working with clients on electronic trading solutions, developing an expertise in ETF trading. Paige graduated in 2009 from the University of Virginia.