Post-2008, ETFs have made their way into pension portfolios largely due to one big promise – liquidity. As plan sponsors continue to use ETFs for basic cash management and exposure to different sectors of the market, liquidity is more important than ever before. But how can plan sponsors be sure that a given ETF offers the right level of liquidity? By asking the right questions. Here are four major ones that will not only reveal how an ETF works but whether or not it delivers the liquidity it promises:
How is liquidity maintained?
ETF liquidity is about more than trading volumes, especially for institutional investors looking for large blocks. Plan sponsors have to ask questions about how a provider handles price discovery and execution especially in thinly traded markets.
Are there liquidity providers?
Liquidity providers can make it possible for large investors like pension funds to access ETFs in markets that are typically too illiquid or small for institutional money (i.e., some emerging markets or currencies). Plan sponsors should ask about the role of liquidity providers in any given ETF – who are they, what do they do and how do they add value?
Is there counterparty risk?
Some ETFs can deliver unwanted exposure to counterparty risk, especially if derivatives are used. Plan sponsors need to ask specific questions about the type and level of counterparty risk in a specific product. That added layer of complexity can impact liquidity especially in tough market conditions.
In the past, how have difficult markets affected the ETF’s liquidity?
ETFs are becoming a risk management tool for some plan sponsors. That means it’s important to ask about how a product has performed in times of stress – has it remained liquid and if not why? Understanding how the ETF works in tough times can provide an excellent insight into how it works in all market conditions.