ETFs look like stocks. They trade like stocks. And the two are similar—up to a point. But when it comes to ETF liquidity, there's more to the story than just trading volume.
Primary vs. Secondary liquidity
When you talk about ETFs, you have to talk about two different kinds of trades.
Most retail investors—and even some institutions—trade in what's known as the "secondary market," meaning they buy and sell the pool of ETF shares that already exist.
In the secondary market, ETFs trade just like stocks. The "secondary liquidity" is determined mostly by the volume of ETF shares currently moving about.
For investors making large trades, however, the situation is different.
ETFs differ from stocks in one big way: Share supply is flexible. If there's demand for an ETF, a special class of institutional investor known as an authorized participant (AP) can "create" new shares at any time. They do so by buying up the securities in the ETF's basket and turning them in for ETF shares with the issuer. Likewise, they can "redeem" shares by doing the reverse, turning in large blocks of ETF shares for an equal value of underlying securities.
This is an ETF's primary market. Its liquidity is determined by how easy it is for APs to create and redeem ETF shares.
Here's the catch: Liquidity in one market—primary or secondary—isn't indicative of liquidity in the other.
Levels Of Liquidity
Which liquidity matters more comes back to who's doing the buying.
In the secondary market, what matters most to investors is how easy it is to trade the ETF shares currently in play, regardless of what the individual securities comprising the fund may or may not be doing.
In the primary market, however, the liquidity of the securities backing the ETF is paramount. After all, the more easily an AP can access those securities, the more efficiently she can create and redeem shares.
So if, say, there's a supply crunch of ETF shares in the secondary market, investors could circumvent that by going to the primary market and asking an AP to create new ETF shares. All you'd need is the ability to trade in big enough share lots—on the order of 50,000 or so.
Of course, most of us can't do that, so we're stuck trading in the secondary market. To assess secondary liquidity, look at statistics such as bid/ask spreads, average trading volume and premiums/discounts to NAV.
Market Or Limit Order?
When it comes time to actually make an ETF trade, you have a few choices.
You could go with a market order, where you tell your broker to buy or sell an ETF right now at whatever price it takes. But that can backfire in several ways, not the least of which being that there's no guarantee your trade will execute at a favorable price. So market orders should only be used for the largest, most liquid ETFs, and where split-second timing is crucial to your strategy.
For all else, there's the limit order. With a limit order, you tell your broker the maximum price you're willing to pay, or if you're selling, the minimum price you'll take. Limit orders protect you from bad executions, although it can mean your trade won't execute if the market moves away.