The one thing that people have not stopped talking about since the flash crash is ETF liquidity.
A large percentage of the readers of my weekly investment newsletter, The 10th Man, are sweating over what happens to ETF liquidity in the event of a downturn. “Will it disappear? Are ETFs the portfolio insurance of this decade?” And so on.
So, if you buy an ETF, will you be able to get out?
For most ETFs, the answer is yes.
Let’s Look at SPY for Instance
In SPY’s case, lots and lots of robots post liquidity—bidding and offering to buy or sell stock “out loud” in SPY, and ready to hedge with either S&P 500 futures or a basket of S&P 500 stock.
These robots are arbitrageurs and are competing with each other to make tiny profits on each share of SPY bought or sold.
The liquidity in SPY is very, very deep. In 2006, I did a trade in SPY that was about $400 million… and it hardly moved the market at all.
If you own shares of SPY, chances are you are going to be able to sell it—unless there is an electromagnetic pulse. In fact, it’s not likely that SPY would deviate much from its net asset value even if someone dumped $10 billion worth on the market.
The Same Is Not True for All ETFs
There are a dozen different ways to arbitrage SPY: through S&P 500 futures, to options, to the underlying stock, or other derivatives. There is a very complex web of derivatives that holds the liquidity in the complex together.
That’s not the case with a lot of ETFs.
There is hardly any liquidity at all in the example we used last week: the Nashville ETF (NASH). As I wrote this article, the market is 27.86 bid, at 27.99, 300 x 700 shares up.
Likely, the issuer of NASH has persuaded one lonely market maker to provide liquidity in it. It is probably unprofitable for him to do so. Is there a chance that he could pull the plug on the computer during a crisis?
Yes. And then you would be stuck with NASH and unable to sell it.
That is an extreme example. There are other funds that can be temporarily overwhelmed by volume, usually around the market open, but those intervals of time are pretty short.
In my old job, I would always tell people that the average daily volume you see on the screen is not a good measure of liquidity, because the liquidity of the ETF really depends on the liquidity of the underlying.
But what you care about as an individual investor is the likelihood that you can get out of the trade at a price that approximates the NAV of the fund.
That will be the case 99% of the time in 99% of the ETFs. You could have a temporary dislocation, like the flash crash. As a general rule, anyone who sells in a panic is usually unhappy with the prices later.
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