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© 2010, Morningstar, Inc. All rights reserved.

ETF Liquidity Explained

Bradley KayAssociate Director, European ETF Research

Ben Johnson ETF Strategist

September 29, 2010

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Agenda

×What is liquidity?

×How the ETF marketplace works

×Why the biggest ETFs keep gathering more assets

×Rules of thumb for ETF execution

×Outlook for the future

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What Is Liquidity?

×The ability to buy and sell a security without moving the price

×Factors contributing to greater liquidity×Lots of existing shareholders leads to natural

buyers and sellers×General agreement on the value of the

security×Ready supply of capital for market makers

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Liquidity in ETFs

×Liquidity in European ETFs currently comes almost entirely from market makers who create or redeem shares at the end of day

×Requires a slight spread between buy and sell prices, to compensate market makers for the costs of hedging

×Market makers are paid to keep spreads at a pre-specified level (typically below 1% or 2% for some less-liquid funds)

×Since the market maker has to hedge, the liquidity of ETF portfolio holdings and ease of borrowing capital matter

×The largest ETFs move toward liquidity coming from existing shareholders

×Allows for the lowest transaction costs, since buyers and sellers are happy to receive fair value

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How an ETF Works

ETF Provider

Market Maker

Stock ExchangeBuyer Seller

(In-kind transfer)

ETF SharesSecurities

ETF Shares

Primary MarketSecondary Market

ETF Creation/Redemption

Process

6

How a Traditional Fund Works

Graphic Source: Blackrock

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Liquidity in Traditional Funds versus ETFs

×Traditional funds still need to tap the capital markets each day in order to buy and sell portfolio holdings

×Not immune from the transaction costs incurred by market makers crucial to ETF trading

×Some ability to avoid transaction costs by netting inflows against outflows

×ETFs force the purchaser or seller to bear the cost of their trade, while traditional funds spread it among all existing shareholders

×Makes the cost of liquidity explicit×Provides the ETF shareholder with a measure

of control over their transaction costs

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Why This All Matters

× Intra-day liquidity allows you to see the price where you are buying and selling, rather than waiting for the end of day

×Allows you to rebalance a portfolio immediately, rather than waiting a day or two to get out of one fund and into another

×The creation and redemption process, and the secondary market on the stock exchange that allows it, is the key to ETFs’ low costs

×Only interacting with a handful of major market makers keeps accounting costs minimal

×Pushes trading to arbitrageurs and trading firms who can do it for the lowest cost, since they make the market at the margin

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Does It Work?

×The arbitrage process keeps market prices for the ETF extremely close to fair value, even as assets change rapidly

× If the underlying securities in an ETF are liquid, then the ETF will be as well under the majority of market circumstances

×Unlike stocks, new ETF shares can be created, so prices do not get driven up substantially by asset inflows

×Example: a new US ETF from entrant Schwab× Intended for retail investors, so inflows came

from many sources× Invests in large-cap US stocks, a very liquid

underlying market×Assets grew 100-fold, from $2 million to $237

million, in only six months

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Does It Work?

Source: Morningstar Direct

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Liquidity Over Time

×Liquidity within all securities markets can vary drastically over time

×Most visible in ETFs, since their bid/ask spreads make the costs of trading explicit

×During market crises, spreads will generally widen as market makers lose access to hedging capital and investors become less certain about fair values

×The largest ETFs in the US kept a steady market through the 2008-2009 crisis, sometimes providing far more liquidity than their underlying securities

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Dangers of Illiquidity

×Typically not much of a problem to buy into a less-liquid ETF

×May require more patience if it is not monitored actively by market makers

×May require going directly to a market maker

×The loss of liquidity during a crisis tends to be steepest for smaller and less liquid ETFs within a category, as these are most reliant on market makers keeping an orderly market

×Not saved in a traditional fund, as they still need to sell securities in the vanishing market to meet share redemptions

×Costs spread among all existing shareholders

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How to Measure Liquidity

×Simple approximations for liquidity×More assets =more potential buyers and

sellers×Greater daily volume = more flow, lower

margins demanded×Liquid underlying = easy hedging for market

makers

×More precise measures of liquidity×Bid/ask spread×Depth of order book (XLM)×Premium/discount×Market impact from past trades

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Bid / Ask Spreads

×A large component of buying and selling costs for ETFs is the difference between the bid and the ask

×Larger ETFs typically have tighter bid/ask spreads

< $5 Million Assets

> $10 Billion Assets

Bid 25.68 106.39

Ask 26.16 106.4

Spread 1.85% 0.01%

Data as of August 30th, 2010

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Bid / Ask Spreads

×Liquidity costs are a crucial consideration when comparing ETFs tracking similar or identical indices

Net Assets €M

TER (%)

Daily Average Trades

Daily Average Turnover €M

Spread (bp)

∆M% Daily

Average Trades

Daily Average Turnover €M

Spread (bp)

∆Ytd%

Amundi ETF EURO STOXX 50 (D) CD5 FP EURO STOXX 50 1 0.15 2.77 0.02 4.73 -4.27 1.55 0.01 4.48 - Lyxor ETF EURO STOXX 50 MSE FP EURO STOXX 50 5,119 0.25 299.36 27.75 5.77 -4.05 395.06 41.46 5.44 -8.55EasyETF EURO STOXX 50 B ETD FP EURO STOXX 50 448 0.25 10.64 0.65 11.96 -4.24 19.01 1.27 13.61 -8.97HSBC EURO STOXX 50 ETF 50E FP EURO STOXX 50 32 0.15 5.14 1.27 15.65 -4.26 7.04 1.24 14.00 -11.85EasyETF EURO STOXX 50 A ETE FP EURO STOXX 50 24 0.25 1.82 0.00 22.85 -4.22 3.25 0.10 36.00 -9.27EasyETF EURO STOXX 50 ETB FP EURO STOXX 50 164 0.25 1.14 0.02 24.03 -6.44 3.75 0.12 37.00 -11.73Source: NYSE Euronext, Morningstar Direct

August Ytd

Name Ticker Underlying Index

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Premiums and DiscountsPremium / Discount to NAV history

-0.20%

-0.15%

-0.10%

-0.05%

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%iShares Russell 2000iShares S&P 500

×Smaller fluctuations in the past = more liquidity

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Rules of Thumb for Trading

×Use limit orders rather than market orders×Does not rely on a deep order book×Allows you to set a fair price for the purchase

or sale×Market makers can see your order on the

exchange and fill it

×Stop-loss orders tend to cause the biggest problems

×Drops a market order on the exchange when prices are going down

×Tends to place a sell order precisely when liquidity is lowest

×Led to major losses in the May 6 “Flash Crash” in the US

×Circuit breakers on European exchanges will keep losses smaller, but not prevent them entirely

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ETF Trade Execution Gone Wrong

×ETF with nearly $1 billion in assets under management

×Relatively strong liquidity in the secondary market

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ETF Trade Execution Gone Wrong×Too large of a market order for the immediate

liquidity on the exchange×Market makers do not always want to post

their full order size on funds that they are not constantly monitoring

×This order executed at a variety of prices, with the peak being 19% above fair value

×After the market order went through the books, the bid immediately came back down to near the fair value of the ETF

×Could have been avoided by using a limit order×Look at iNAV to see what fair value of the

portfolio is×Bid, ask, and recent trade prices also give a

good idea of the current fair value

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Fair Value Pricing

×The iNAV is not always accurate× Foreign stock ETFs trade in Europe even when the

underlying markets are closed × Events can arise when local markets are closed that will

impact valuation once trading opens, but iNAV may not incorporate that change in value

× Market makers rely on futures, local listings of foreign shares, demand changes, and proprietary algorithms to determine a security’s “fair value”

× If a large number of trades are occurring at fairly tight spreads, that suggests a reasonable market price even if it differs from iNAV

Graphic Source: Vanguard

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Trading Best Practices

×Use limit orders

×Avoid stop-loss orders

×Evaluate the market× Indicative values×Recent trade prices×Bid / ask quotes×Avoid trading during extreme volatility (Flash

Crash)

×Trade when the underlying market is open and functioning

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The Future for European ETF Liquidity

×Most investors are still large, slow-trading institutions

×Even the highest volume ETF in Europe only trades about £50 million per day through the exchange, less than 1/250th of the volume traded through SPDRs (the world’s largest and most liquid ETF)

×The market is still reliant on market makers and could face some trading disruptions in another major crash

×Liquidity is growing rapidly×Hedge funds are shifting toward using ETFs in

place of OTC derivatives from investment banks

×Retail investors and advisers are starting to buy off LSE, Deutsche Börse, and Borsa Italiana

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ETF Liquidity is Growing Rapidly

Exchange YTD Trades % Change YOY YTD Turnover (M) % Change YOYDeutsche Borse - - € 107,975 33.3%London Stock Exchange 831,707 35.1% £67,316 47.7%NYSE Euronext 1,406,420 4.5% € 64,126 14.0%Source: Deutsche Borse, London Stock Exchange, NYSE Euronext

×Year-to-date trends through August are encouraging

×Though the trend is positive, there is still a long way to go

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The Future for European ETF Liquidity

×ETFs pulling in the greatest amount of assets and putting up the largest volumes will continue to succeed

×Lower trading costs mean a lower total cost of ownership

×More purchasing across the European exchanges

×A spread that’s only one penny tighter on a £10 share is worth £100 on a £10,000 trade

×Biggest ETFs will keep their liquidity even during a crash

×Likely to end up as one of the lowest-cost ways to trade illiquid asset classes like fixed-income and foreign markets during a crisis

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