How can an investor choose the right ETF?

We generally associate investment risk with loss of capital, volatility or volatility in the prices of listed securities, forex risk, stock taking risk, etc. The effect of ‘immobility’ is also a significant risk in listed securities such as stocks and exchange-traded-funds (ETFs).

Real estate liquidity is prone to risk and this is well understood by most people, however, the same parameter is somewhat misunderstood in listed securities such as ETFs.

Sometimes in an hour of crisis we may be forced to sell a property like our home where the final real sale price may be much less than its fair price in the market due to liquidity.

This is also known as a crisis sale, in which the lack of liquidity in the market (the buyer) is responsible for the realization of the low price. The opposite can also be true, where the buyer has to pay a price much higher than the fair value of the asset due to lack of liquidity.

As far as ETFs are concerned, one tends to focus on common parameters such as total expense ratio (TER) and tracking error (TE) of an ETF. However, ETF liquidity as measured by daily average volume is probably one of the most important factors an investor needs to consider when choosing the right ETF within their peer group.

The ‘Trio’ of Daily Average Volumes, TER and TE are an ETF selection checklist and analyzing these in combination tells us that, ‘Not all ETFs are created equal’.

Liquidity constraints translate into a high ‘impact cost’ for both buyers and sellers in the context of listed securities like ETFs.

Impact cost represents the indirect cost of executing a transaction, for a specific predetermined order size in a particular stock or ETF, compared to its ideal price at any given time. Impact cost is a practical and realistic measure of market liquidity.

For example, the exchange terminal tells you that the best buy order is for 1,000 ETF units. Best sell orders for the 980 and 2,000 ETF units 982, therefore the ideal price defined as the average of the best buy and sell orders is 981 ( 980+ 982) / 2. But let’s say you were able to buy 5,000 shares of the ETF at an average cost of 991, so your impact cost is 1% (991-981)/981. This means that you incur an indirect transaction cost of 1% to buy 5,000 shares due to the liquidity position in that stock.

However, if the same security has high trading volume or high liquidity, the execution price may be relatively lower in terms of buying or selling.

In the case of illiquid ETFs, this bid-ask spread is the cost that an investor incurs to enter or exit a security in the secondary market. We can clarify the above by taking the following examples of Nifty 50 and Nifty Bank ETFs. However, as we dig deeper and observe the average daily volume of each of them, we see a huge difference. This is when the reality ‘not all Nifty 50 ETFs are created equal’ is clear.

ETF A has the highest daily average volume of 31.17 cr and 22.19 cr on a 1-year and 3-year basis, respectively, while ETF B has a volume of about 1/5 of that of ETF A.

The above difference would directly result in a relatively low liquidity impact cost for ETF A, meaning the lowest execution price compared to its ideal value for an investor, depending on the quantity of the order size.

This is similar to the difference between liquid and illiquid stocks – the former have lower bid-ask spreads and hence, the liquidity impact cost of entry/exit is much lower.

From this example, we understand that because of the high daily average volume, Nifty 50 ETF A is the natural choice for an investor.

To confirm this we can take one more example and the following data of Nifty Bank ETF will make it clear.

‘Not all Nifty Bank ETFs are created equal’ is illustrated by the Nifty Bank ETF A’s highest daily average volume in comparison to its peers.

The choice of an ETF in its peer group is most importantly determined by the daily average volume.

If the ETF does not have sufficient liquidity, a profit is negated due to low TE and low TER, adding to the high liquidity impact cost of the investor. I can conclude by saying that volume is as important to ETFs as blood is to the body.

Hemen Bhatia is the Head of ETF at Nippon India Mutual Fund.