Liquidity in equity markets is plunging again amid rising global trade tensions and is raising costs for active stock pickers who move quickly in and out of positions. After a brief bounce in the first part of the year, liquidity for single stocks is approaching the bottom reached during the stock selloff last December and according to a measure used by Goldman Sachs, it has fallen as much as 64% since mid-2017. But when liquidity dries up, active managers could be aided by strategies that make use of exchange-traded funds (ETFs), according to a recent story in Bloomberg

“There is a business case that active managers could better utilize passive vehicles in the short term to help manage in and out of stock positions, particularly in periods of market volatility and stress,” wrote Goldman strategists in a recent research note. “One area that seems relatively less explored is the potential to be a source of liquidity.”

ETFs: the New Active Management Tool when Liquidity is Low

· Liquidity for single stocks is down 64% from levels in mid-2017;

· ETFs trading in lockstep with their equity holdings, but with more liquidity;

· Passive products account for just 4% of total assets managed by active funds.

Source: Goldman Sachs

What it Means for Investors

The bank’s strategists found that ETFs were trading at comparable rates to the equities that comprise their holdings, but with one major difference—the ETFs were trading with much more liquidity. That’s an important difference since it means traders are able to save cash on liquidity premiums, especially in the current low-liquidity environment when those premiums become significant. 

Bid-ask spreads for the average ETF over the past year have been approximately 40% tighter than for those of the stocks being held in those ETFs, the strategists found. That means buying and selling ETFs has not been producing big price swings. At least not as big as those produced by individual stocks, and that means lower costs for traders, according to Bloomberg.  

While Goldman’s research suggests active managers may want to begin making greater use of passive ETFs in times of low liquidity, especially considering that passive products currently only account for 4% of total assets managed by active funds, the recent plunge in liquidity is raising other concerns as well. When liquidity began to dry up in late December of last year, a number of market strategists began making comparisons to the early stages of the 2007-2008 global financial crisis.

The large unwinding of quant funds in August of 2007 precipitated a loss of market liquidity and acted as a harbinger of later market turbulence, according to Deutsche Bank. In comparison, hedge fund redemptions have surged since October of last year, just prior to December’s massive selloff and the subsequent drying up of liquidity.

The most widely traded ETFs include the (SPY), the iShares MSCI Emerging Markets ETF (EEM), the Financial Select Sector SPDR Fund (XLF), the Invesco QQQ Trust (QQQ) and the iShares Russell 2000 ETF (IWM).

Looking Ahead

Another factor contributing to the declining of liquidity has been the Federal Reserve’s unwinding of its own balance sheet over the past couple of years, which had expanded during successive rounds of quantitative easing (QE) in the aftermath of the financial crisis. On that note, Federal Reserve Chair Jerome Powell’s reassuring comments earlier this week in the wake of ongoing trade conflicts suggest the U.S. central bank is standing ready to provide liquidity in order to sustain economic growth. In the meantime, active managers may want to consider ETFs to satisfy their liquidity needs.