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 Frontier and emerging markets seem to have extreme reputations—big gains, terrible losses, less predictability and more volatility than developed markets. While these offer challenges for most investors, those using indexes or ETFs should also be concerned about liquidity and difficulties that ETFs and index managers may face in some markets.
The "index effect"—the tendency of a stock to bounce upward when it is added to an index—is widely discussed and can be seen in emerging market indexes as well as in the S&P 500. The effect occurs not only when new stocks are added, but when almost any adjustments are made necessary by changes in an index. Explanations for the index effect are common sense: In the S&P 500, index funds and ETFs as a group hold about 10 percent of the outstanding shares of each stock in the index. Adding a new stock is similar to running a buyback program to absorb 10 percent of the shares in a few weeks. In size, this is several times greater than a typical corporate buyback program.
With the rush of assets into the emerging markets space over the past few years, and with the potential of a move of significant assets into the frontier markets soon, there's the potential for the index effect to grow in these markets too.
Liquidity
One thing that counters the index effect is liquidity. Liquidity reflects the expense or difficulty involved in buying, or selling, a position without moving the price. If a stock is liquid, investors and indexers can buy or sell large amounts without much risk of a significant price squeeze. If it is not liquid, even small purchases may push a price sharply higher.
Measuring liquidity is easier said than done. First, it is hard to find a variable that tracks the difficulty of trading without moving the price; and second, the data one wants are not always available.
Rather than dive into an academic study of how to gauge liquidity, this article focuses on three related measures where the data can be found: dollar value traded, turnover and days-to-trade.
Dollar value traded (DVT) is the total dollar value of the stock that traded in a time period—in our discussion, a month. It measures how much action there is in the stock and can be compared to the amount an indexer is buying or selling to determine how large an impact the index buying might have.
Turnover is the ratio of shares traded in a month (or some other time period), to shares outstanding. It gives a sense of how much of a company's total ownership is moving through the market. As with dollar value traded, the higher the number, the more liquid is the stock.
Days-to-trade (DTT) measures how many days it will take to acquire or divest of a position of an assumed size given recent trading levels. If 10 percent of a company's total shares turn over in a month and indexers as a group will acquire 10 percent of the stock, it would take a month if they account for all the trading that month.
While this measure can be used in many circumstances, here we consider it with regard to an index add or drop that makes it necessary for index funds to buy or sell a stock. Various assumptions are needed to calculate DTT, including how much of the routine trading can be absorbed in an index adjustment without paralyzing the market, and what proportion of the total market cap of the index is held by indexers.
DTT can be explained through the formula used to calculate it:
The first bracketed term is the reciprocal of monthly trading volume; the 20 percent figure is the assumption that the index adjustment should absorb only 20 percent of the usual activity. The second fraction in the first bracket converts from months to days; we assume 20 trading days per month. The lower the DTT measure, the better.
All these measures involve one key caveat—markets may respond to increased trading, so liquidity may increase when demand for shares rises in response to index adjustments.
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