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Mifid II promises a new era for European ETF trading

by Emma Dunkley on Dec 28, 2012 at 07:00

However, as Fuhr notes, ETF liquidity does not just boil down to how much these products are traded on the secondary market. ‘ETFs are as liquid at the underlying,’ she says, arguing it is the liquidity of the basket of constituent stocks investors really need to look at.

Indeed, an ETF has two main sources of liquidity, based on the stocks underlying the fund and what it is trading at. Liquidity can be affected by market conditions, such as if the underlying market is closed or at times of investor uncertainty.

For example, ETFs on the US market are pretty liquid, versus a product on Vietnam. There is an established futures market covering the US, so it is easier to gauge where the markets will be and price from this. Conversely, emerging markets do not have such a developed futures market, meaning it is more a case of taking a view, which could lead to these ETFs having wider spreads.

Dubois at Lyxor says: ‘We make sure we have a strong secondary market; we don’t do marginal indexations where secondary market trading is not good.’

Indeed, there are some underlying asset classes where investors may have concerns as to the level of liquidity. Corporate bonds funds, for example, have come under the FSA’s scrutiny in the UK, with the watchdog questioning how managers can meet redemptions.

Although the ETF market is small compared with the broader European Ucits fund industry, there are new types of products coming to market that help address some of these concerns. Deutsche Bank, for example, recently launched a liquidity-focused corporate bond fund, which tracks an index comprising bonds that have been screened for liquidity.

To form part of the index, the bonds must have a remaining time to maturity of at least two years and a minimum outstanding of £400 million. By focusing on liquidity, the ETF can more efficiently track the index based on liquid components.

Manooj Mistry, head of db X-trackers for the UK, says: ‘There has been a strong demand for corporate debt exposure this year, so having this liquid, low-cost access tool will be useful for investors. This is a big advantage over traditional corporate bond ETFs, where the investor has to accept tracking difference risk, which can be substantial because of the potentially illiquid nature of the underlying.’

As well as monitoring the liquidity of the underlying, investors should look at the trading volumes of the ETF, while taking into account that the number is only a snapshot of the true amount traded. With Mifid II on the horizon and the RDR imminent in the UK, the amount of trades is set to increase, spurring liquidity as more investors pile in to buy these low-cost, efficient and transparent products.

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