Understanding ETF liquidity
As exchange-traded funds (ETFs) and stocks both trade on an exchange, investors may assume that, like stocks, ETF liquidity is determined by the volume of trading or outstanding units. This leads to the common misconception that ETFs with lower average daily trading volumes are less liquid or, in other words, more difficult to trade and have wider spreads.
What does ETF liquidity have to do with its underlying securities?
While trading activity on an exchange is the most visible source of liquidity, what truly governs ETF liquidity is the underlying securities of the portfolio, not the number of units or trading. For example, 1,000,000 units of an ETF would maintain the same liquidity as just one unit of the same ETF that tracks the same underlying securities.
Said differently, if an ETF holds securities that are difficult to trade, don’t trade at a significant daily volume or have a low supply, then the ETF’s liquidity could be an issue.
Creation and redemption makes ETF liquidity distinct
In contrast to the finite supply of individual stock shares available, ETFs can issue or withdraw shares from the primary market as necessary through a process known as creation and redemption. The creation and redemption process is a unique differentiator compared to individual stocks, and helps explain why ETF assets or trading volume do not necessarily determine ETF liquidity.
ETFs have designated brokers and market makers (dealers) who will hold inventory of the ETF units. Once there is enough demand in the ETF, these dealers would approach an ETF issuer to create a new unit (creation unit, typically 50,000 shares) of the ETF. This can be done by submitting the underlying securities of the ETF or cash, or a combination of the two. After the purchase is settled, the dealer can move their inventory of ETF units to the secondary market (a stock exchange).
The redemption process works in reverse – physical securities, cash or a combination of both (held by the ETF issuer) are returned to the dealer to facilitate the redemption, or cancellation, of these units.
Other important aspects to keep in mind
Price, or NAV, of an ETF is determined by the value of the underlying basket of securities, not the supply/demand of the ETF shares.
The supply of ETF shares is open-ended, which is different than stocks because there are a limited number of shares that are issued.
The main source of liquidity for an ETF is based on the trading activity of the securities in the underlying basket.
The main measure of liquidity for an ETF is the average daily trading volume of the securities in the underlying basket of the ETF.
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