Volume and the Hybrid Nature of the ETF Vehicle

by David Mann of Franklin Templeton, 4/23/21

Investors choose particular exchange-traded funds (ETFs) for many reasons, but volume and liquidity are often important considerations. David Mann, our Head of Global ETFs Capital Markets, says the importance of volume may depend on whether one wants to trade the ETF like a stock, or a fund.

In my last post on taking the time to appreciate ETF liquidity I hinted that there would be further discussion at some point on using stock metrics for measuring the liquidity of a hybrid stock/fund instrument. I must admit, my thinking on this topic has once again evolved.

Hopefully by now, readers of this forum know that when trading larger sizes of an ETF, its average volume does not tell the whole story. My first blog post back in 2016 discussed how ETF market makers can leverage the liquidity of the basket; I discussed how larger net asset value (NAV) trades are not included in an ETF’s average volume (here) and (here). Heck, I have even tried analogies such as restaurant dining and buying mattresses online.

Admittedly, my opinions on ETF liquidity have typically been from the perspective of the lower-volume ETF. To say larger trades cannot be executed efficiently because of a lack of average daily volume is just plain wrong, and I have a briefcase of examples as proof. However, to say that ETF volume has no value whatsoever would also be disingenuous.

So, how should we then think about the importance of ETF trading volume when selecting an ETF? I think a lot depends on whether the investor wants to trade the ETF like a stock, or like a fund. I fully acknowledge that this view is a bit simplistic, but I think it does acknowledge the hybrid nature of the vehicle:

  • “Like a stock” – short holding times (<2 months) and/or use of options
  • “Like a fund” – a long-term investment into a diversified portfolio of securities

As we have seen thus far in 2021, investors do like to “day-trade” stocks, and that includes ETFs as well. This is a slightly different conversation than earlier this year when I discussed internet message boards and whether they could increase an ETF’s volatility. There are now well over 2,000 ETFs in the United States, many of which provide very niche exposures (sometimes with leverage!). Investors who trade in and out of these funds can have holding times measured in days, and when trading that frequently, the average daily volume of that ETF certainly matters.

But as the holding time becomes longer, the ETF’s average volume becomes less and less important since there is so little trading involved with this investment. Trading-related questions should fade, replaced with those on the fund itself. For example, when comparing passive funds of similar exposures, are there lower fee options available given the impact of higher management fees over the long term? When comparing active funds to passive funds, what is the active philosophy that merits investment over the passive equivalent?