Capacity and liquidity are closely linked. The problem with the first is that you must be large, but not too large to move in the market. The problem with the second is the market can move against you.
Last April, when the $4.8 billion (£3.7 billion) VanEck Vectors Junior Gold Miners ETF got so big it had to start trading outside its index, concerns about capacity became more prevalent.
The ETF tracked a small subsector of the gold mining industry, and many suggested the specificity of the circumstances had little relevance to the broader market. However, others saw it as a microcosm of what they suggest are worrying underlying weaknesses in the market.
One industry figure to voice concern was Algy Smith-Maxwell, a director of fund management at Jupiter Merlin. He says investors’ beliefs that equity markets are deep and liquid will be tested – and the crunch point will be an inability to trade in the ETF market.
‘My fear is there will be a test of market liquidity if a lot of people were to rush out of ETFs at the same time, because they would find the door extremely narrow,’ said Smith-Maxwell.
‘At a point in time, QE and the bull market will be reversed and after that it is quite possible that my fear will be tested.’
Back in 2016 the Securities Exchange Commission (SEC) raised concerns about ETFs and mutual funds holding too many securities lacking deep and resilient pools of buyers. He suggested such fears seemed justified.
‘My experience has been that with more specialist ETFs it is easy to buy them, but hard to sell them. I have realised a buy in one day then it took two weeks for me to finalise a sale. This can cause enormous stress upon market liquidity.
‘If there is a weapon of mass destruction then it is liquidity, which may be absent when the market is put under stress.’
He added that Jupiter was happy to use passive vehicles but emphasised it did so tactically, and with the understanding that choosing passive instruments remains an active decision.
A softer line
While agreeing with this as a broad approach, Caroline Shaw, head of fund and asset management at Courtiers, takes a softer line on the balance between liquidity and capacity debate. She sees neither issue as an automatic cause of concern.
She described the VanEck fund as an isolated incident of a very concentrated ETF that was in the wrong place at the wrong time: liquidity was, more generally, a relatively easily manageable factor.
‘When the ETF becomes the same size as the index that’s when you start to have problems, but I don’t think we are that close to that happening,’ she says.
‘If you are investing in frontier markets then, yes, you have a liquidity issue. If Nigeria, for example, is dropped out of the market, someone who wants to sell Nigerian stocks will have a problem. I wouldn’t want to be in that index, but this is happening in countries in which you shouldn’t be investing anyway.
‘My main worry is finding the less costly option. There are arguments about how some aspects, like more data or transparency, can justify higher cost but generally if you want to replicate and everything is the same cost is a big factor.’
New developments, such as smart beta, have given rise to new considerations. Ben Seager-Scott, chief strategist at Tilney, says ETFs have always worked in very liquid markets such as the S&P 500, but now they are proliferating in much more junior exchanges and asset classes.
‘My biggest concern is people misunderstanding those products, because they look simple, but they can be very complicated,’ he says. ‘Liquidity is one of the most important factors that you need to watch closely and it comes back to people not fully grasping how ETFs work.’
Retail customers, especially those who do not take advice, are one area of concern. But investors need to do their due diligence on ETFs too, not just when they take active management decisions.
Tilney has a fair amount of positions in passive instruments. It mainly uses them for the most liquid parts of the market and says it is very careful to work diligently to avoid having to try to trade when the markets are stressed.
‘ETFs give you interesting liquidity but you are relying on the secondary market. Often, when markets are stressed, it may not be the time to trade.’