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The Dynamics of Liquidity and Investing

Nate Geraci December 15, 2015

BlackRock’s Matt Tucker explains the concept of liquidity and sheds some light on the dynamics of liquidity and exchange traded funds:

I’ve been getting questions recently about liquidity, specifically in the context of exchange traded funds (ETFs). Liquidity is a hot topic in financial markets these days, so let’s spend a little time going over it. First, we’ll explore what we mean by “liquidity” and then we’ll explain what it means when it comes to ETFs.

Defining liquidity

When I think about liquidity, I think about a transaction: I am able to buy or sell something at a known price. The more liquid an investment, the easier it is to buy and sell without affecting the asset’s price. More fully, liquidity has three main components: price, time and size. If an asset is liquid, I can trade it quickly, and I can trade a large amount of it, without moving its price. In reality, most investments involve trade-offs between these three components. Want to trade quickly? You may not be able to trade a large amount, or you may impact the price you are going to receive. Want to trade a large amount? Do it slowly, or be prepared to impact prices. A general rule of thumb for liquidity for most investments is that you can get two of the three attributes, but not all three at once.

If we consider liquid assets, a large cap stock is a good example. Unless you are trading a significant number of shares, you can generally trade fairly quickly at a price that is close to what you see on the exchange. A home, on the other hand, is relatively illiquid; you can get an estimate on its price, but until a buyer signs on the dotted line and you have a check in hand, it’s unclear what you’ll actually get when selling your home. And it will generally take you a while to sell your home, no matter what its size.

Liquidity and ETFs

When it comes to a security like an ETF, I can see that it’s trading at a certain price, and I can generally buy or sell that ETF at a price that’s pretty close to the quoted price. I can generally trade fairly quickly, as long as my trade is not large compared to the security’s volume. A large ETF trade is in some ways similar to a large equity trade; I need to trade over time or risk impacting the price.

Let’s take it a step further and look at bond ETFs. If you want to go out and buy a bond, you can’t just buy it on the open market via an exchange. Instead you would buy it over the counter, in a negotiated transaction with a broker. The price you would trade at is often unclear, and it can be difficult to trade a large amount, or trade quickly. In fact, some investors may find that individual bonds don’t have any of the three aforementioned features of liquidity. With a bond ETF, which is a basket of bonds traded on an exchange, you have much more price transparency. You can actually see the price at which a bond ETF is trading and have a sense of the price of a trade and how many shares might be available to trade at that price. As the bond ETF trades on an exchange, you can generally trade it with the same speed as an individual stock. The liquidity rule of thumb still applies to bond ETFs; it can be difficult to trade in large size, quickly and without impacting price, but overall, exchange trading liquidity can be greater than liquidity in underlying markets. And that is an improvement that all investors can benefit from.

 

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to the The Blog.

 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

When comparing stocks or bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual stocks or bonds.

©2015 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.

Taking Advantage of Tax Loss Harvesting with ETFs

Nate Geraci December 3, 2015

The following was authored by WisdomTreeETFs.

For financial advisors, this is the time of the year to talk taxes with their clients, especially if they have capital gains. Investors may be unaware that their mutual funds can have capital gains—even when the market is down. In fact, even when a mutual fund’s NAV is down, it may have had capital gains from the sale of a security (ETFs can have capital gains too; it’s just far less frequent due to their tax efficiency).

And with capital gains come capital gains taxes. One effective way to potentially reduce capital gains taxes (and potentially even ordinary income taxes) is tax loss harvesting.

Tax loss harvesting

This practice enables investors to sell an investment that is down to create a capital loss that offsets the gains in another investment. Doing so can help you reduce, or eliminate, the capital gains taxes. Some investors even use this practice to help reduce ordinary income taxes in a year without capital gains (for this purpose, you can only claim a loss of up to $3,000 per year).

Of course, in order to meet long-term goals, it’s best to remain invested, so what’s an investor to do? Often, after selling the “losing” investment, investors desire simply to buy it—or something similar—back at the lower cost. But this is where the 30-day wash-sale rule comes in.

The 30-Day Wash-Sale Rule

The rule basically states that if an investor buys a “substantially identical” investment within 30 days of the sale of another investment, it essentially cancels out that earlier sale. In other words, they won’t receive the tax benefit they had hoped for.

This is where ETFs can be extremely helpful. Not only are ETFs created and managed in a way that makes it easier to manage capital gains taxes within them, but the IRS also does not yet (and perhaps never will) consider them “substantially identical” to mutual funds.

Strategies for Tax Loss Harvesting

Here are some ways investors could implement a tax loss harvesting strategy.

• Strategy 1: Sell security B to offset gains in security A. Buy an ETF with exposure to the sector or industry that security B is in. On day 31, you can sell the ETF and reinvest in security B, or you can keep holding the ETF for the long term.

• Strategy 2: Sell mutual fund D to offset gains in mutual fund C. Buy an ETF with a similar objective to mutual fund D. On day 31, you can sell the ETF and reinvest in mutual fund D, or you can keep holding the ETF for the long term.

• Strategy 3: Find ETF alternatives for all your mutual fund holdings. As ETFs tend to be more tax efficient (they do not need to sell securities for redemptions and are able to use in-kind distributions, so they tend to have capital gains far less frequently), they may be a wise move for the long-term health of your portfolio.

’Tis the Season—for Considering Tax Efficiency of Investment Vehicles

Important Risks Related to this Article

Neither WisdomTree Investments, Inc., nor its affiliates, nor Foreside Fund Services, LLC, or its affiliates provide tax advice. All references to tax matters or information provided in this material are for illustrative purposes only and should not be considered tax advice and cannot be used for the purpose of avoiding tax penalties. Investors seeking tax advice should consult an independent tax advisor.

Some mutual funds have an objective of tax efficiency.

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