Why Liquidity Matters

In Europe, there’s long been more focus on trading than assets in ETFs. And that’s not a bad thing.

I LOVE the Volkswagen story, Paul. It is the classic short squeeze tale. Fewer and fewer publicly available shares are on the market until it becomes obvious that the squeeze is on, and then no shares are available just when the hedge funds need them to cover their shorts. And Volkswagen sits there twiddling their thumbs and saying “What, me?” Everybody likes to see the short-man squeezed. It’s like seeing the guy betting with the house on the don’t-pass line go down in flames.

The problem is that the squeeze can also do wild things to the index the stock is in, as happened with the DAX. This is why we’ve got a free-float on indexes, and though the DAX people may have been late to take action (maybe they enjoyed seeing their index soar and watching the short-guys get crushed), they DID ultimately take down the free-float weight appropriately and take some of the pressure off of the index and VW. Interesting little story—really a textbook squeeze story somewhat along the lines of the great Nikkei 225 squeeze story that is covered in the excellent book “Ugly Americans” (by the author of “Bringing Down the House”).

And Paul—while we’re on the subject of liquidity, there are some ETFs with spreads you could drive a truck through trading in Europe. And that MATTERS. The odds are, if you’re trading one of those ETFs, you’re on the wrong side of that spread and are effectively playing a huge load (up-front fee) when you purchase the fund. Starting with a 200 bp handicap is not wise.

The lesson to be learned here is that, while the U.S. ETF industry said for years that spreads and premiums/discounts to the NAV were ALL about the underlying, it’s not really true. In Matt Hougan’s groundbreaking study originally published in our JoI publication, he actually found better correlation between ETF assets and trading volumes to their spreads than their actual underlying assets correlation to ETF spreads. Have a look—it’s also interesting to compare the spreads Matt shows to those Paul shows in the European markets. As you might expect, the U.S., with wider spread assets and trading volume, has less-concentrated liquidity, assets (and trading spreads) than the products in Europe.

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