Identifying whether an ETF has satisfactory liquidity has long been a major challenge for the ETF Industry. ETFs are the fastest-growing investment vehicle in history because they solve many of the shortcomings inherent to stock investing. ETFs provide instant diversification and the elimination of idiosyncratic company risk. They are also almost infinitely liquid because of their unique Creation/Redemption feature, in which Authorized Participants (usually large brokers) can add or remove shares from the market as needed, based on demand. However, determining if an ETF is liquid or not is not so clear.
ETF liquidity differs greatly from stock liquidity, and you cannot measure their liquidity using average daily volume, price times volume, or any similar metric. ETF liquidity really depends on the liquidity of the underlying stocks in which the ETF invests. For example, a brand new ETF that only trades 100 shares a day in its first few weeks would still have a massive amount of liquidity if it invested in stocks in the S&P 500 index. You could drop $100 million in that ETF and see the trade executed quickly because the S&P 500 index can absorb $100 million without a problem. On the other hand, an established ETF that trades 500,000 shares a day may have great difficulty filling that same trade if it invests in stocks in a tiny market niche such as Nanotechnology.
This characteristic presents an inherent problem for the small investor. Investors don’t want to have to wait days for completion of their trade if they purchased a sizeable amount of an ETF based on a fairly illiquid niche. Nor do they want to be stuck in an illiquid ETF that can’t be easily sold.
ENTER FACTSET — the company on which P123 began relying for data in mid-2020. FactSet has a ranking it maintains on every ETF, called the “FactSet Analytics Block Liquidity” ranking. It ranks all ETFs on a scale of 1 to 5 (5 being best) for the ease with which a $1 million block trade can be filled. To date, we’ve had to manually check this liquidity rating before investing in an ETF. It also causes backtests to be inaccurate because we can’t replicate this manual screening in a backtest.
You can find this FactSet information on the ETF.com website and others. For example, you can look up the rating for the S&P 500 ETF (SPY) at [url=https://www.etf.com/SPY]https://www.etf.com/SPY[/url]. The site’s layout maintains a column on the right side with many different measures. If you scroll about halfway down the page, you’ll see a section titled “SPY Factset Analytics Block Liquidity.” It shows five blue blocks for SPY, indicating a ranking of 5 of 5 for the ease of trading a $1 million block of shares.
We’ve established a FEATURE REQUEST for P123 to add this crucial “Factset Analytics Block Liquidity” data from FACTSET for every ETF in its database. This would ensure that the liquidity rating for each ETF is always up-to-date, backtests will be accurate, and P123 users will always invest in ETFs that have ample liquidity.
Please take a moment to VOTE for this important FEATURE REQUEST! Thank you!
Chris