Friday, October 30, 2009

Picking the right ETF: Liquidity

Lack of liquidity is treacherous for everyone.

Catastrophe in capital markets is always characterized by a lack of liquidity. Significant imbalances between buyers and sellers (widened bid-ask spreads) can create market “gaps”. Occasionally this happens to the upside but predominately it occurs on the downside. Examples: October 1987, September 2001, Q4 2008. Liquidity is important for investors, but a lack of liquidity is treacherous for everyone.

Liquidity of underlying securities

Since the 1990 launch of the first exchange-traded fund (ETF), the Toronto Index Participation Securities (TIPS), liquidity has been important. Originally developed for retail investors, TIPS became popular among institutional investors seeking broad market access in part because of the liquidity of the 35 stocks underlying TIPS. It follows that ETFs with illiquid holdings should be watched carefully. Fixed income ETFs can fall into this category.

Theoretically, trading volume and liquidity for today’s ETFs is not a problem with the creation/redemption mechanism. This structure authorizes designated brokers to create additional units if demand exceeds supply, and conversely, remove units when supply exceeds demand. But there are differences in bid-ask spreads impacting every investor’s bottom line that require explanation.

Timing and volume

“An ETF manager may be doing a terrific job of tracking an index,” says Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, “but the retail investor may still be impacted by liquidity costs, paying a hefty price in the form of wide bid-ask spreads or volatile premiums/discounts to net asset value (NAV), all resulting in less than stellar market liquidity.

“Transacting before a holiday or at other times when volume is expected to be low, can be expensive and should be avoided. For example the closing bid-ask spread for actively traded iShares CDN S&P/TSX 60 (XIU), as of Friday, October 9, 2009 (Thanksgiving weekend) was $17.08-17.10 or 11.7 bps (normally about 5.8 bps) and for less actively traded Claymore Canadian Fundamental Index ETF (CRQ), was $10.85-10.99 or 129 bps (normally about 28 bps). Bid-ask spreads are generally correlated with trading volume and tend to be tighter for ETFs with more assets under management as the examples above demonstrate. 3 month average trading volume: XIU 17.6 million shares vs. CRQ 35,632 shares. The chart below demonstrates that trading volume and bid-ask spreads are correlated. This is not a surprise. More activity reflects popularity which suggests better arbitrage opportunities to keep spreads narrow and ETF values close to NAV.

“Poor liquidity can cost investors money. Most ETF prices oscillate around their NAV. The absolute level of premium/discount and its standard deviation, a measure of how far, on average, the market price of an ETF tends to deviate from the NAV, warrants scrutiny. Some ETFs, primarily fixed income, trade mostly at a premium. For these ETFs, the magnitude of the average premium depends on the liquidity of the underlying assets, a good example being iShares Canadian Real Return Bond ETF, (XRB). Due to the limited depth of the Canadian real return bond market, this ETF tends to trade at a premium to NAV, closing at $20 on October 9, 2009 with a NAV of only $19.75, or a 1.27% premium.”

The daily historical premium/discount to NAV for the XRB is shown below.


The overall measure of ETF liquidity is a combination of factors; bid-ask spreads, fund assets, trading volume, premium-discount and last, but not least, the liquidity of the underlying assets. Imbalances can lead to tracking error that can distort strategies (to be covered in a future article).

If investors intend to hold positions for longer than 6 months, liquidity may be less of an issue, but larger spreads can be costly over time to frequent traders. A rule of thumb for liquidity is that if the securities underlying the ETF are popular, the ETF’s construction is transparent, and trading is active, liquidity should be pretty good.

PŮR Investing Inc. offers a free ETF screener on their website that includes liquidity:

Picking the right ETF: Diversification

PICKING THE RIGHT ETF: Diversification

First of a series of articles exploring how to sort and evaluate exchange traded funds.

The need

Exchange-trade funds (ETFs) have had the most profound impact on personal investing since the introduction of the modern mutual fund in 1924. To the advantages that drove mutual fund growth; diversification, professional management, and shared expenses, ETFs have added low costs, transparency, market access throughout the trading day and tax efficiency.

Institutions lead the use of ETFs for effective acquisition and hedging of portfolio positions. In 2008, the ability to short financial ETFs while shorting individual financial company shares was banned is only one example of the value of these instruments.

With over 100 ETFs trading in Canada, over 800 in the U.S., and over 500 more in registration, this rapidly expanding universe demands better selection tools.

These articles will explore key factors for evaluating ETFs beyond simple categorization and screening. Diversification, liquidity, cost, tax efficiency and tracking error will be examined for their impact on portfolio construction.



Diversification is a method to control risk by limiting exposure to any one holding. Institutions typically diversify by:

 asset class (stocks, bonds, cash, real estate, commodities, currency)
 region (domestic, foreign, emerging markets)
 style (value, growth, core)
 size (large cap, mid-cap, small cap)
 sector (financials, materials, technology, energy)

All of these are available via ETFs. Individual investors no longer need millions of dollars to get broad exposure.

How to measure it

The quantitative way to measure diversification is by measuring the specific (idiosyncratic) risk in a portfolio. The less specific risk there is, the better the diversification. Specific risk is the risk "specific" to a security, not explained by systematic market factors (such as energy prices, interest rates, etc).

Specific risk is a metric routinely calculated by risk models. Investors without access to risk models can use PŮR’s “rule of thumb” approach:

 total number of securities (PŮR recommends at least 50),
 weight represented by the top 10 holdings (PŮR recommends under 30%)
 weight of maximum individual holdings (PŮR recommends 10%).

Why it is important

According to capital market theory, specific risk is not rewarded. That's why minimizing exposure to this risk by increasing diversification makes sense. Better diversification can mean less variability in a portfolio’s value. Professionals call this “risk management”, investors call it “sleeping at night”.

How it works

The principle is based on the idea that prices of selected assets can move independently from one another (uncorrelated). Good diversification means lots of different risks not lots of different assets, as many investors often forget. ETFs’ risk is more reliable than that of individual securities because it is dampened by the variety and number of their holdings. The result offers a more effective approach to portfolio construction.

What are you trying to do?

Are you an investor or a trader? This will impact how you choose ETFs.

Investor: Your investing horizon is 5 years plus and you’re looking to overweight areas of the economy that will outperform. You need to manage risk, so diversification is important. Selecting the more diversified ETFs from different asset classes, regions, styles, sizes and sectors is a good way to succeed.

Trader: Your investing horizon is lunchtime tomorrow (maybe up to one year). All you need to predict price movements is in price, volume and trading statistics. You gain by exploiting volatility and you trade frequently. Ironically, ETFs dampen volatility! Nevertheless, it may be easier to make a call on a sector (like financials) rather than a single security (like TD Bank ). Diversification is a two-edged sword for you, but is useful in assessing broad or specific exposure to underlying indices.


An ETF’s diversification is a function of the number, concentration and nature of its holdings.

iShares CDN Large Cap 60 Index Fund (Symbol: XIU) with 60 holdings vs. iShares CDN Composite Index Fund (Symbol: XIC), with 220 holdings, illustrates similar ETFs with different diversification. While similar, the XIC is somewhat better. This doesn’t necessarily mean that XIC is the better choice however. As we will see in a future article, cost is a very important factor.

The iShares CDN Tech Sector Index Fund (Symbol: XIT) with only 5 holdings is a very concentrated ETF that would score low on diversification but may be interest traders.

Single commodity-based ETFs represent pure systematic risk. They are asset classes by themselves. Some U.S. ETFs track commodity indices that have different sector concentrations. Look before leaping.


Diversification is one the most important factors in ETF evaluation. It is central to portfolio construction and an important reason for ETF popularity today. In the next issue, we will discuss liquidity, important for when the $%^t hits the fan as it did in 2008.

PŮR Investing Inc. is a registered portfolio manager specializing in risk managment using exchange traded funds. PŮR’s free ETF screener is available at: