How liquid is your ETF?

This article originally appeared on benefitscanada.com

This past summer, a trading glitch at exchange-traded fund (ETF) market maker Knight Capital resulted in a dizzying 30-minute roller-coaster ride on the NYSE.

Orders suddenly and inexplicably flooded in for about 150 stocks, and spreads ballooned for a handful of less-liquid ETFs. It left investors scratching their heads and put Knight Capital in the spotlight.

More importantly, though, it shed light on the crucial role that authorized participants’ play in the day-to-day trading of ETFs.

The key message: it’s important to look under the hood and understand the trading dynamics behind ETFs.

Read: The limits of liquidity

Right now, pension funds are using ETFs in greater numbers, mainly as a way to manage cash during manager transitions and to add liquidity to an existing asset allocation.

And when liquidity is king, investors must understand how ETF trading dynamics within an ETF work. They can have a big impact on costs, according to a research paper released in October by the Investment Trading Group (ITG).

Its research looks at 12 popular ETFs, and reveals that all of them exhibit different characteristics when it comes to liquidity and costs. It all boils down to the limit order book.

It says, “The limit order book for ETFs is deeper than that for common stocks with similar daily share volume, price, spread and volatility characteristics, especially at price levels immediately surrounding the prevailing mid-quotes.”

For investors, this means the costs of instantaneous executions are significantly lower for ETFs than for the matched common stocks. But, limit order books of ETFs can be highly volatile as well, since he number of ETF units that can be raised by climbing the limit order book change constantly.

Every ETF has an optimal point in the day when liquidity will be at its peak, however.

Read: Lack of liquidity is treacherous

Therefore, say the authors of the paper, investors must understand how an ETF’s shares are created and redeemed to be able to understand how it achieves that crucial balance.

If they don’t, they’ll end paying more than expected when trying to make a quick exit.

Read:

Institutional managers key to ETF growth

Tracking ETF error

Safety tips for synthetic ETF use