We normally associate investment risk with loss of capital, fluctuation or volatility in prices of listed securities, foreign exchange risk, stock picking risk and so on. The impact of ‘illiquidity’ is also an important risk in listed securities like stocks and exchange traded-funds (ETFs).

Illiquidity risk in Real Estate

Real estate is plagued with illiquidity risk and this is well understood by most people, however, the same parameter is somewhat misunderstood in listed securities such as ETFs. Sometimes in an hour of crisis we may be forced to sell assets like our house with distress selling wherein lack of liquidity in the market (buyers) is responsible for lower price realization The reverse can also be true wherein due to lack of liquidity a buyer ends up paying a much higher price as compared to the fair value of the asset.

Illiquidity risk in ETFs

As far as ETFs are concerned, one tends to focus on the usual parameters such as total expense ratio (TER) and tracking error (TE) of an ETF. However, ETF liquidity as measured by daily average volumes is perhaps the one of the most critical factors that an investor will have to consider while choosing the right ETF, i.e., within its peer group. The ‘trio’ of daily average volumes, TER and TE are an ETF selection checklist and analysing these in combination tell us that, ‘all ETFs are not created equal’. Lack of liquidity with reference to listed securities like ETFs translates into a high ‘impact cost’ for both buyers and sellers.

Impact Cost

Impact cost represents the indirect cost of executing a transaction in a particular stock, or ETF, for a specific predefined order size, at any given point of time as compared to its ideal price. Impact cost is a practical and realistic measure of market liquidity.

For example, the exchange terminal tells you that there is a best buy order for 1,000 ETF units at ₹980 and best sell order for 2,000 ETF units at ₹982, hence the ideal price defined as average of the best buy and sell order is ₹ 981 ( ₹980+ ₹982) / 2. But suppose you were able to buy 5,000 shares of ETF at an average cost of ₹991, hence your impact cost is 1% (991-981)/981. It means you incurred an indirect transaction cost of 1% to buy 5,000 shares because of the liquidity conditions in that stock. However, if the same security had high trading volumes or high liquidity, then the execution price in case of purchase or sell may have been relatively lower.

Average daily volumes

This bid-ask spread in case of an illiquid ETF is the cost that an investor has to bear for entering or exiting the security in the secondary market. We can illustrate the above by taking the following examples of Nifty 50 and Nifty Bank ETFs. However, as we dig deeper and observe the average daily volumes of each of them, we notice a stark difference. This is when the reality ‘all Nifty 50 ETFs are NOT created equal’ is apparent.

ETF A has the highest daily average volume of 31.17 crores and 22.19 crores based on 1 year and 3 years respectively, whereas ETF B has a volume nearly 1/5th of ETF A.

Impact cost affected by Daily average volumes

The above difference will directly result in the relatively lower liquidity impact cost for ETF A, implying the lowest execution price for an investor as compared to its ideal price, depending on the quantum of order size.

This is akin to the difference between liquid and illiquid stocks – the former has lower bid-ask spreads and therefore, entry / exit has a very low liquidity impact cost. From this example, we understand that on account of high daily average volumes, Nifty 50 ETF A is the natural choice for the investor.

We can take one more example to reaffirm this point and the following data of Nifty Bank ETFs will make it clear. ‘All Nifty Bank ETFs are NOT created equal’ is illustrated by the highest daily average volumes of Nifty Bank ETF A as compared to its peers.

The choice of an ETF in its peer group is decided most importantly by daily average volumes.

Conclusion

An advantage due to lower TE and lower TER gets negated if the ETF does not have adequate liquidity, leading to high liquidity impact cost of the investor. Volumes are as important to an ETF as blood is to the body.

Source: Mint Money article published on 15^th February 2022