The Foundations of ETF Liquidity Part I: From Concept to Creation

Building Liquidity From the Ground Up

Asset Class Considerations

The first step in creating an ETF is deciding what it will track, which directly influences its liquidity profile:

• Equities:

Domestic vs. Foreign: Domestic equities generally offer greater liquidity due to their deeper markets, while foreign equities—especially in emerging or frontier markets—can present challenges like settlement delays, currency risks, and local market constraints. For instance, certain markets impose stamp taxes or have stringent capital controls that directly affect trading efficiency.

Broad vs. Thematic: While broad indices like the S&P 500 are inherently lifuid, niche or thematic ETFs may depend heavily on the liquidity of individual components. For example, industry-specific funds (e.g., electric vehicles) might have significant weight in a few stocks, amplifying risk and illiquidity.

• Fixed Income:

Liquidity varies significantly by bond type. U.S. Treasuries are highly liquid, while corporate, municipal, and high-yield bonds often trade in fragmented markets with limited transparency.

The illiquidity of certain bonds can lead to wider spreads, impacting investor costs and market maker support.

• Commodities:

Physical commodities (e.g., gold) provide direct exposure but require storage and insurance considerations.

Futures-based commodities like oil or natural gas come with complexities like roll yield and contango, affecting both performance and liquidity.

• Currencies, Derivatives, and Leveraged ETFs:

Products tied to currency markets or derivative strategies introduce unique liquidity risks tied to central bank policies, volatility, and leverage mechanics.

Avoiding the Liquidity Trap

One critical pitfall is launching a product without thoroughly evaluating its liquidity profile. Rushing to market with innovative ideas may lead to ETFs that perform well in the short term due to price movements in their components but create problems when those moves are driven by illiquidity or unsustainable market conditions.

For instance, during the early days of cannabis ETFs, stocks like Tilray surged in value. This wasn’t due to intrinsic fundamentals but rather due to limited float and speculative demand. The dramatic price moves created short-term excitement but left investors exposed to volatility and losses when liquidity dried up.

ETF capital markets experts are crucial in addressing such risks. By evaluating component liquidity, potential short squeezes, and broader market impacts, they can guide issuers in designing more resilient and sustainable products. They also help issuers navigate constraints like stamp taxes, settlement delays, and operational risks to ensure smooth trading for the end investor.

The Importance of Market Viability

Rushing a product to market without assessing liquidity needs is a common pitfall. While niche or thematic ETFs might appear innovative, their success depends on the practicalities of managing liquidity.

ETF capital markets experts can help product managers evaluate:

• Underlying Asset Liquidity: Do the fund’s components trade in sufficient volume to support secondary market activity?
• Regulatory Constraints: Are there tax issues, capital controls, or settlement delays that could complicate liquidity?
• Operational Challenges: Are there complexities in hedging or managing the portfolio, such as dealing with currency risks or trading in fragmented markets?

By addressing these questions early, experts can help issuers align their products with market realities, ensuring a smoother launch and long-term viability.

Final Words

ETF liquidity begins with a strong foundation. It’s not just about identifying an investment theme—it’s about ensuring that the theme can be effectively executed in the market. Issuers must balance innovation with practicality, leveraging the expertise of ETF capital markets professionals to design products that meet investor needs without sacrificing liquidity.

By taking a deliberate and informed approach, issuers can navigate the complexities of today’s global markets, addressing constraints and aligning their offerings with the practical realities of trading. This ensures that ETFs remain efficient, accessible, and resilient, reinforcing their role as the cornerstone of modern investing.

About the Author

Nicholas Phillips | President of ETF Capital Markets Advisors LLC
With over 25 years of experience in ETF market making and capital markets, Nicholas Phillips is recognized as a subject matter expert in the ETF industry. He started his career spending the first ten years as a lead market maker for SIG and Goldman Sachs. At the helm of MCAP LLC's ETF Desk, Nicholas built and scaled the division, enhancing its operations through innovative pricing and risk models, and robust relationships with market makers and issuers. His tenure at Van Eck Associates as Director of ETF Capital Markets further solidified his expertise, managing critical facets of operations and deepening connections within the trading community. Beyond market making, Nicholas is an avid content creator, sharing insights that demystify complex market dynamics. He is keen on exploring board member roles that benefit from his extensive background and forward-thinking approach to ETF strategies. His dual US/Ireland citizenship complements his global perspective, enriching his professional endeavors in diverse markets.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.