Understanding ETF Liquidity

For individual stocks, liquidity is about trading volume and its regularity—more is better. For ETFs, there's more to consider.

An ETF Isn’t A Stock

ETFs are often lauded for their liquidity and single-stock trading characteristics. Truth is, they are similar.

If an ETF doesn’t trade a certain number of shares per day (e.g., 50,000), the fund is illiquid and should be avoided, right? Wrong. It’s a plausible assumption from a single-stock perspective, but with ETFs, we need to go a level deeper. The key is to understand the difference between the primary and secondary liquidity of an ETF.

Primary Market Vs. Secondary Market

Most noninstitutional investors transact in the secondary market—which means investors are trading the ETF shares that currently exist. Secondary liquidity is the “on screen” liquidity you see from your brokerage (i.e., volume and spreads), and it’s determined primarily by the volume of ETF shares traded.

However, one of the key features of ETPs is that the supply of shares is flexible—shares can be “created” or “redeemed” to offset changes in demand. Primary liquidity is concerned with how efficient it is to create or redeem shares. Liquidity in one market—primary or secondary—is not indicative of liquidity in the other market.

Another way to make the distinction between the primary market and the secondary market is to understand the participants in each. In the secondary market, investors bargain with each other or with a market maker to trade the existing supply of ETP shares. In contrast, investors in the primary market use an “authorized participant” (AP) to change the supply of ETP shares available—either to offload a large basket of shares (“redeem” shares) or to acquire a large basket of shares (“create” shares).

The determinants of primary market liquidity are different than the determinants of secondary market liquidity. In the secondary market, liquidity is generally a function of the value of ETF shares traded; in the primary market, liquidity is more a function of the value of the underlying shares that back the ETF.

When placing a large trade—on the scale of tens of thousands of shares—investors are sometimes able to circumvent an illiquid secondary market by using an AP to reach through to the primary market to “create” new ETF shares.

Unfortunately, most of us aren’t trading tens of thousands of shares at a time, so we’re stuck trading in the secondary market. Remember that, to assess secondary market liquidity, you should be looking at statistics such as average spreads, average trading volume, and premiums or discounts (does the ETF trade close to its net asset value?).

It’s really only if you’ll be trading close to 50,000 shares or more at a time that these statistics are no longer the most relevant in assessing liquidity. For those big trades, the liquidity of the ETF’s underlying securities is the most important factor.

After all, to “create” 50,000 shares, the AP must first submit a prespecified basket of the ETF’s underlying securities—a creation basket—to the ETF. There is a direct relationship between the underlying liquidity of an ETF and its primary market liquidity, because in order to create primary market liquidity, the AP must trade in the underlying market—the easier an AP can access the underlying market, the more efficiently she can create and redeem ETF shares.

If you trade this size regularly, a good first step is to contact the ETF issuer itself and request the capital markets desk. One of the main goals of the issuer’s capital markets desk is to ensure that investors enter and exit funds at fair prices. They can also be a great help in providing market impact estimations, underlying liquidity analysis and connecting investors to liquidity providers.

Next: ETF Fit: Does My ETF Give Me The Exposure I Really Want?

Other Articles Of Interest

Understanding Spreads And Volume
What Is The Creation/Redemption Mechanism?
Understanding iNAV

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