A Lesson in Ratios and ETF Liquidity

In the last edition of this newsletter, I discussed getting into back-to-school mode with my kids. One month later with both kids enjoying middle school, I find myself needing to up my game to ensure I can still answer all their math-related homework questions. Quick tangent: the way math is taught these days is WAY different than it was back when I was in middle school and yes, I did walk to school uphill both ways in the snow. My daughter was recently plowing through fractions and ratios without too much resistance. But toward the end, started complaining aloud that there was no point to this lesson as she would never use them in her life. As soon as the words left her mouth, I think she realized she had made a terrible mistake.

My kids should know better than to question the usage of mathematics, especially in front of their father, who also happens to author a bestselling ETF Capital Markets newsletter. I then had to decide which example of ETF industry ratios I should highlight for her. Given my recent call to have some better statistics within the ETF industry, I think the timing was perfect to revisit the ratio of an ETFs secondary market (exchange) volume-to-gross primary market (create/redeem) activity.

The early days of an ETF

Why should an investor care about this ratio? For starters, it’s a decent gauge of how much ETF trading reaches the underlying markets. In the early days of an ETF, I would expect this ratio to be close to one as there are no existing shareholders who can sell shares to new investors. Likewise, there may not be any buyers in case one of the early shareholders wants to sell. As a result, ETF market makers must create (or redeem) shares to match any on-exchange demand. New ETFs will often see this ratio in the 1 to 2 range.

Investor adoption increases

As time passes, more trading occurs between new investors and existing shareholders without the involvement of ETF market makers, or similarly ETF market makers are actively buying and selling shares throughout the day. ETF volumes start increasing and typically bid/ask spreads start decreasing. There is now a greater likelihood that investors can transact on exchange without the need of ETF market makers trading the ETF’s underlying securities. ETFs that fit into this category usually see ratios in the 3 to 8 range—something we’ve recently seen in our largest single-country passive ETFs.