Future liquidity of ETFs

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Future liquidity of ETFs

Postby TS1 » Wed Dec 26, 2012 2:45 pm

Hi all,

Spreads on the major Vanguard ETFs are very small now, but I was wondering if an investor with a time horizon of decades might have any reason for concern over whether those spreads might not always be such. Perhaps the popularity of Vanguard ETFs, or ETFs in general could wane. A lot can change over that long a time. Would there be a safe way out (i.e., ability to cash out at/near NAV) that I am not aware of?
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Re: Future liquidity of ETFs

Postby rmelvey » Wed Dec 26, 2012 2:47 pm

If this is a serious concern of yours you might want to stick with the index mutual funds. You can be assured that you will always be trading at the NAV.
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Re: Future liquidity of ETFs

Postby nisiprius » Wed Dec 26, 2012 10:03 pm

Surely you'd be able to see it coming? I don't see how you could suddenly go from today's near-perfect liquidity and narrow spreads to a real problem all it once. After all, even if the bid/asked were to widen to, say, 1%, that would still hardly be a disaster, would it? Whatever factors were to make ETFs unattractive would surely be obvious, apply to many ETFs, and would manifest as a slow trend heralded by news articles.

What's the scenario under which an ETF could become so illiquid so quickly that selling it would involve a serious hit to your portfolio?
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Re: Future liquidity of ETFs

Postby natureexplorer » Wed Dec 26, 2012 11:02 pm

TS1 wrote:Spreads on the major Vanguard ETFs are very small now, but I was wondering if an investor with a time horizon of decades might have any reason for concern over whether those spreads might not always be such.
Not only can spreads increase, but your ETFs could also start trading at a discount.

Whether the onset is sudden or not, will not even make a difference in the face of taxable gains.
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Re: Future liquidity of ETFs

Postby natureexplorer » Wed Dec 26, 2012 11:04 pm

nisiprius wrote:What's the scenario under which an ETF could become so illiquid so quickly that selling it would involve a serious hit to your portfolio?
The scenario does not have to be predictable to be possible.
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Re: Future liquidity of ETFs

Postby tetractys » Wed Dec 26, 2012 11:19 pm

For lay investors, trading ETFs with GTC orders pretty much makes any worry about spreads a mute point. -- Tet
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Re: Future liquidity of ETFs

Postby JamesSFO » Thu Dec 27, 2012 12:21 am

natureexplorer wrote:
nisiprius wrote:What's the scenario under which an ETF could become so illiquid so quickly that selling it would involve a serious hit to your portfolio?
The scenario does not have to be predictable to be possible.


I will just add that when markets fail they are capable of doing so rather spectacularly and severely. Eventually it will likely correct, but eventually may be the wrong time horizon for you.
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Re: Future liquidity of ETFs

Postby TS1 » Thu Dec 27, 2012 1:44 am

Regarding discounts to NAV, isn't it true that institutional holders can redeem shares in-kind, and would this not prevent a significant discount from developing as a separate issue from the spread?
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Re: Future liquidity of ETFs

Postby grabiner » Thu Dec 27, 2012 2:01 am

tetractys wrote:For lay investors, trading ETFs with GTC orders pretty much makes any worry about spreads a mute point. -- Tet


These orders have a different risk. Suppose that you place a Good-Till-Cancelled order on Wednesday to sell your ETF at a limit $50. It happens not to sell, with a closing value of $49.90. While the market is closed, something happens to raise stock prices. On Thursday, the market opens up 2%, so the opening value is $50.90; your order is still around, so a trader takes the $50 order and you sell for 90 cents less than the market value.

This is much less of a risk with a day order, because ETF prices change reasonably continuously; if an ETF is worth $49.90 at 1:59, it won't be worth $50.90 at 2:00. (Even that is a risk with stock orders; if a corporation announces a new product or reports higher-than-expected earnings at 2:00, its price will jump and stale limit orders will get taken for a ride.) You could avoid the GTC risk by canceling the order on Thursday before the market opens and then reissuing it at a proper price, but at that point, you're just using a series of day orders.
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Re: Future liquidity of ETFs

Postby ftobin » Thu Dec 27, 2012 1:10 pm

grabiner wrote:These orders have a different risk. Suppose that you place a Good-Till-Cancelled order on Wednesday to sell your ETF at a limit $50. It happens not to sell, with a closing value of $49.90. While the market is closed, something happens to raise stock prices. On Thursday, the market opens up 2%, so the opening value is $50.90; your order is still around, so a trader takes the $50 order and you sell for 90 cents less than the market value.

All ordinary trades must execute within the NBBO (national best bid and offer). A trader is not allowed to execute your sell order at less than national best bid during market hours (and I'll note GTC orders are only valid during regular market hours).
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Re: Future liquidity of ETFs

Postby nisiprius » Thu Dec 27, 2012 1:34 pm

JamesSFO wrote:
natureexplorer wrote:
nisiprius wrote:What's the scenario under which an ETF could become so illiquid so quickly that selling it would involve a serious hit to your portfolio?
The scenario does not have to be predictable to be possible.
I will just add that when markets fail they are capable of doing so rather spectacularly and severely. Eventually it will likely correct, but eventually may be the wrong time horizon for you.
Sure, but remember we are talking concerns specific to ETFs. Liquidity of ETFs. If all the market in general crashes and trading is suspended or whatever, then everything crashes, ETFs, traditional mutual funds, individual stock portfolios. That's a market issue, not an ETF-specific issue.

The concern here is about a situation in which individual stocks are still liquid, mutual funds can still sell their shares to meet redemptions, and yet ETFs would become illiquid and/or trade at a steep discount.

I'm not even sure how to fantasize about that. Someone finds some very serious software bug that affects ETFs but nothing else, and all ETF trades are frozen for weeks while they rewrite the software, and meanwhile you cannot sell your ETFs but a few sharp operators are willing to lend you an advance on your ETF at usurious rates? If not that, what exactly is the ETF-specific black swan scenario we are talking about? Maybe the ETF provider fails and there's nobody around to create the "creation units?"
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Re: Future liquidity of ETFs

Postby baw703916 » Thu Dec 27, 2012 1:40 pm

All ordinary trades must execute within the NBBO (national best bid and offer). A trader is not allowed to execute your sell order at less than national best bid during market hours (and I'll note GTC orders are only valid during regular market hours).

But what happens at 09:30:00.001? For an illiquid ETF, it may be the case that the market maker hasn't put anything in the order book yet, or that there's a huge imbalance. So somebody with HFT capabilities could put in a bunch of lowball bids on the off chance that some of them might execute.
Most of my posts assume no behavioral errors.
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Re: Future liquidity of ETFs

Postby JamesSFO » Thu Dec 27, 2012 1:45 pm

nisiprius wrote:The concern here is about a situation in which individual stocks are still liquid, mutual funds can still sell their shares to meet redemptions, and yet ETFs would become illiquid and/or trade at a steep discount.

I'm not even sure how to fantasize about that. Someone finds some very serious software bug that affects ETFs but nothing else, and all ETF trades are frozen for weeks while they rewrite the software, and meanwhile you cannot sell your ETFs but a few sharp operators are willing to lend you an advance on your ETF at usurious rates? If not that, what exactly is the ETF-specific black swan scenario we are talking about? Maybe the ETF provider fails and there's nobody around to create the "creation units?"


Unsure. Most I can come up with would be linked to a specific ETF provider having problems. Which might be more problematic than for a mutual fund because of the requirement for creation unit redemptions/etc. Further, the top 3-4 ETF providers have like 80% of ETF AUM, so a problem affecting even 1 ETF provider could have a massive impact.

I think the broader point still stands: clarity about what can happen usually happens after the fact. If you were holding, say, Greek bonds in 2012, it was fine until it wasn't. In theory you should have had time to lower/reduce your position, but in practice you might not have had the time.

(BTW, I still will happily hold ETFs as well as mutual funds)
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Re: Future liquidity of ETFs

Postby natureexplorer » Thu Dec 27, 2012 1:48 pm

Have people forgotten the ETF flash crash that was unpredictable?

Have people forgotten ETNs and what happened to them unpredictably?

Have people forgotten what has happened to LTCM unpredictably?
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Re: Future liquidity of ETFs

Postby JamesSFO » Thu Dec 27, 2012 1:55 pm

Btw, http://www.indexuniverse.com/sections/etf-league-tables/15513-etf-league-table-as-of-dec-24-2012.html shows that BlackRock (BR) together with State Street (SSgA) and Vanguard (VG) have nearly 85% of all ETF assets under management (AUM).

If just BR and SSgA had issues, 66% of the ETF universe would be disrupted. VG has the "odd" duck ETF/mutual fund structure so it is harder to say how that would play out. But, say BR trading systems get hacked or one of their counterparties threatens to withhold clearing? Look what happened to MF global, the firm fell apart suddenly (admittedly due to corrupt accounting/trust handling) but if BR were to go under suddenly ETFs outside BR could be highly disrupted for several days/weeks/months.

Again, not a reason not to hold ETFs but something to be aware of.
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Re: Future liquidity of ETFs

Postby ftobin » Thu Dec 27, 2012 2:07 pm

baw703916 wrote:
All ordinary trades must execute within the NBBO (national best bid and offer). A trader is not allowed to execute your sell order at less than national best bid during market hours (and I'll note GTC orders are only valid during regular market hours).

But what happens at 09:30:00.001? For an illiquid ETF, it may be the case that the market maker hasn't put anything in the order book yet, or that there's a huge imbalance. So somebody with HFT capabilities could put in a bunch of lowball bids on the off chance that some of them might execute.

Market makers will have all of their customers' orders in the order book pre-market, ready for the opening cross, or else they risk not having their customer order execute. The market maker eats a loss fixing the trade if the opening price prints through the customer order and reverts to the mean.

Consider a stock trading normally at $55. If a market maker has a customer buy limit at $54, does not put it into the opening cross, and the stock opens at $53, and then moves back to trading around $55, the market marker is obligated to fill the customer's order: sell to the customer at $54, cover at $55, and eat the $1/share loss.

I'll note that many people's concerns about trading have been fixed by regulations or trading mechanisms that have evolved over the past decade. The are even future protections on the near horizon that protect against "flash crashes" (the limit-up limit-down rule, which mandates trades occur within a moving rolling-average band).
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Re: Future liquidity of ETFs

Postby Default User BR » Thu Dec 27, 2012 5:08 pm

There are any number of unlikely events that could happen. The question is whether you want to spend any time worrying about these or take measures against them.

When driving to work, there is a slight chance that some idiot will throw a rock off an overpass and kill me. I know it can happen because it has to other people. So, should I reroute my trip to avoid driving beneath overpasses? What other risks would I add by doing so?

A spiral of worry is no way to live. There is ALWAYS something that can paralyze you with fear.


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Re: Future liquidity of ETFs

Postby natureexplorer » Thu Dec 27, 2012 5:19 pm

Default User BR wrote:There are any number of unlikely events that could happen. The question is whether you want to spend any time worrying about these or take measures against them.

When driving to work, there is a slight chance that some idiot will throw a rock off an overpass and kill me. I know it can happen because it has to other people. So, should I reroute my trip to avoid driving beneath overpasses? What other risks would I add by doing so?

A spiral of worry is no way to live. There is ALWAYS something that can paralyze you with fear.


Brian

The question for me is what risk do mutual funds have that ETFs don't.
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Re: Future liquidity of ETFs

Postby zotty » Thu Dec 27, 2012 5:26 pm

I don't view this as a black swan event. I think it is relatively easy to buy an ETF that is thinly traded and is hard to sell, or cannot be sold, at a reasonable spread from nav. I had some trouble with VSS a while ago.

I prefer liquidity risk to be the problem of the fund manager, not me. I still own VSS. The benefits, compared to the fund, outweigh the risk. However, I would not consider using etfs for TSM or TISM. the benefits do not outweigh the liquidity hazard.

Others can disagree, but this is my position on the subject.
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Re: Future liquidity of ETFs

Postby longinvest » Thu Dec 27, 2012 5:54 pm

natureexplorer wrote:The question for me is what risk do mutual funds have that ETFs don't.


I happened to sell mutual fund parts on the day of the flash crash. I had no idea, having posted the order early morning, before leaving for work. They sold at the deflated NAV based on the closing prices of the day. That was the final trigger that got me into ETFs, so that I could use limit orders to protect against sudden end of trading day market anomalies.

I sleep better at night, not having to wait until the next day to know the result of a transaction.
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