Many investors use point-in-time statistics for the most recent 30 or 90 trading days to assess the liquidity profile of an ETF that has traded on an exchange for longer than just the last 30 days. This is a problem because—with the exception of a few highly liquid ETFs—a fund’s liquidity profile can change in different market regimes. This paper explores how ETFs’ liquidity dynamics impact total cost of ownership (TCO), underscoring why investors need to look beyond a single period statistic when analyzing liquidity.
How Market and Fund Profile Changes Impact Liquidity
Many investment strategies require implementation over different periods, potentially occurring over multiple market volatility regimes and not always during periods of persistent tranquility. Volatility in the broader marketplace can impact the liquidity profile of an ETF in the secondary market, in addition to the liquidity of its underlying securities. The type of client base using an ETF can also impact its liquidity profile in the secondary market and should be considered during the due diligence process. For instance, if a fund obtains an identifiable three-and five-year track record of top-decile performance, it could improve the fund’s liquidity profile through an uptick in activity (volumes and flows) from an investor base seeking a high-performing time-tested strategy. Robust liquidity due diligence, therefore, must be tailored to account for shifts in market volatility, client demand and user base.
To illustrate the value of a regime-dependent due diligence process, we chose two ETFs focused on the same market, which we will refer to as Fund A and Fund B. Let’s compare the TCO based on expense ratio and transaction costs, with other factors (tracking error, commissions) held constant: