by Anthony Chan, Head of iShares Asia Research & Investment Advisory (ARIA), BlackRock
Here is a common dilemma faced by many investors in Exchange Traded Funds (ETFs). Let us say you are bullish on Chinese equities and want to express an investment view. Also assume you are attracted to a sector-based ETF because it has more growth potential than comparable broad-based benchmark products. However, you check market data and see that average dealing volume in the ETF is quite low. Maybe the fund is newly launched and is not yet widely followed. You worry that you will not always be able to trade out of the position – or, perhaps, you will face a high bid-ask spread when it is time to sell.
Such a headache will be familiar to anyone who regularly trades stocks, especially small caps where liquidity is always a concern. ETFs, however, are different because of their unique second layer of liquidity. An easy way to explain this idea is by comparing the ETF market with a noodle stall owner who must sometimes deal with a busier than expected lunch time rush.
On a normal day, the stall owner will have spent the morning preparing ingredients – chopping vegetables, slicing meat and transporting noodles to the stall. Past experience will give him a good idea about the amount of ingredients to prepare. However, in event that he gets a bigger than normal rush of customers, he has the option to quickly buy more ingredients from a nearby supermarket. From the customer’s perspective, it makes no difference whether the ingredients were prepared in advance or assembled at the last minute. They pay the same price for their noodles and have no reason to care how the stall owner manages his inventory of ingredients, just so long as it is properly prepared and cooked in a tasty way.
In the same way ETF participating dealers can create new ETF units when demand becomes very high. They can do this so long as the underlying stock basket has good trading liquidity – think of this as new ingredients being bought from a nearby supermarket. And like our noodle stall owner, the act of creating new ETF units has no impact on the ETF price. For the end investor, they need not worry about the details of what is happening in the kitchen. The same process applies in event of falling prices as sellers out-number potential buyers. In a falling market, ETF primary dealers can exchange the ETF units directly with the fund provider and in return receive either the underlying securities or a cash payment. For the investor, this mechanism provides the comfort that there will always be a counter-party willing to trade the ETF.
The ability to create new ETF units without changing the price means investors should look beyond the quoted volumes offered on their trading screen. This process works especially well when the fund provider works with multiple dealers – think of this as having access to many different supermarkets in the neighbourhood.
