What is ETF Liquidity? Key Insights & Importance

What is ETF liquidity?

ETF liquidity is an important consideration for investors because it impacts the ability to buy or sell an ETF at a reasonable price. In highly liquid ETFs, sellers can easily sell their shares in an ETF at a price close to the net asset value (NAV) of the ETF. ETF liquidity in smaller ETFs is more complicated, and can be a source of concern for some investors.

Why does ETF liquidity matter?

The liquidity concerns associated with normal stocks don’t necessarily apply when trading ETFs. When an ETF doesn’t trade regularly or has low trading volumes, it is often assumed that a prospective buyer will have difficulty buying at a respectable price, and a seller would have difficulty exiting their position when needed. While this is true for stocks, this is not the case for ETF liquidity.

What factors affect ETF liquidity?

Liquidity is affected by several factors.

First, even if on screen volume looks low, the liquidity of the underlying assets is the most important determinant of how liquid an ETF is. The more liquid these are the easier it is for the ETF to absorb large trade orders without affecting the price.

Second, the number of buyers and sellers helps increase trading volume and hence liquidity. There are many drivers of this from investor interest in the strategy, attractiveness of future returns and even how well the ETF is marketed or sold.

Third, to create liquidity requires both buyers and sellers. If one side is imbalanced liquidity can dry up. This happens during market cycles – liquidity is often poor in bear markets or periods of financial stress. The number of buyers often falls and liquidity disappears.

Fourth, higher assets under management (AuM) does often mean higher liquidity, though the converse is not true. Higher AuM also means investors with minimum AuM hurdles can start to trade. These are usually institutional investors who trade in large amounts creating liquidity for other investors.

Finally, the number of market makers and their ETF inventory also helps support liquidity. Issuers often cultivate relationships with market makers in order to create a more fluid market in their ETFs.

Five misconceptions about ETF liquidity?

1. The volume is the only metric one needs to look at. ETF liquidity is more complex than a simple snapshot of volume, even if averaged over time. To properly analyze liquidity one should look at multiple metrics. An important consideration is the liquidity of underlying assets captured by a measure called implied liquidity. This translates the liquidity of the underlying into dollar liquidity of the ETF. Below is a table of Tema ETFs’ implied liquidity – showing total million of dollars that can be traded at many multiples of on screen liquidity.
   
   

Source: Bloomberg as of July 24, 2024

2. Low volumes means low ETF liquidity. As ETFs have a near frictionless primary market the liquidity of the underlying dictates the liquidity of the ETF itself, allowing low volume ETFs to easily absorb large orders.
   
   
3. Low AuM means low ETF liquidity. While it is true that on average the more AuM an ETF has the more trading volume there is, this is only part of the picture. If the underlying assets are highly liquid a low AuM ETF can, using the primary market, absorb big trades.
   
   
4. All order types are the same. Although all order types are possible to get the best price we recommend using limit orders. A market order may use an algorithm designed for normal stocks that sweeps through the standard orders on the order book, and may therefore push the secondary market price far higher or lower than expected.
   
   
5. When you trade an ETF doesn’t matter. Although it is possible to trade ETFs at any point during market hours, including trading pre-market, it is advisable to be more discerning. It is generally better to avoid pre-market trading, and not to trade right at the open to allow market marker models to settle on the NAV and maintain a tight bid-ask spread. For ETFs with a large portion of the underlying holdings in European or non-US assets, it is advisable not to trade after 11:30 am ET, when those markets are closed.

Why is ETF liquidity important?

ETF liquidity matters as good liquidity ensures a smooth, efficient and frictionless transaction of ETF units on the market. Ultimately this improved financial returns. In high liquidity ETFs, a buyer can transact at a price that is not too high relative to the price they see on the screen or the NAV of the fund. A seller can also transact at a price that is not too low relative to the price on the screen or the NAV of the fund. Buying and selling at good prices, improves financial returns for investors from the ETF. It also gives long term holders peace of mind that they can convert holdings to cash should the need arise.

Three layers of ETF liquidity

ETFs have three layers of liquidity.

The first is natural buyers and sellers, as with normal stocks, where you buy or sell using a trading platform, and the platform essentially matches you with a seller or buyer. This is the method of trading in heavily traded ETFs with billions in assets.

The second is for buyers and sellers to interact directly with market makers, who act as a counterparty or broker to match you with a buyer or seller. This is an important part of secondary market liquidity because the market makers hold large inventories of ETFs.

The third layer of liquidity is the creation and redemption mechanism of ETFs, a feature designed to handle the large trade / low on-screen volume problem. This feature is unique to ETFs.

Primary market liquidity

Creation is the process by which Authorized Participants (APs) introduce additional shares to the secondary market. During this process, APs deliver the underlying securities to the fund sponsor in return for ETF shares. For redemptions, the reverse happens.

This ability to continually issue and withdraw shares in on the secondary market (thereby creating a liquid ‘primary market’), means the true measure of an ETF is not in its on-screen liquidity, but is instead predominately determined by the liquidity of its underlying holdings. If the underlying holdings are liquid enough, the AP can create/redeem shares easily.

This process ensures that the price of the ETFs stay as close to NAV as possible. If a secondary market order would result in a discount/premium to NAV, the AP creates or redeems shares to ensure the ETF can absorb large buy or sell orders while continuing to trade at a price close to the NAV of the underlying securities. As a result, it is the liquidity of the underlying securities that matter.

Secondary market liquidity

Just like a stock, the secondary market is where holders of already issued ETF units can transact with would be buyers. This happens on exchanges like the New York Stock Exchange (NYSE) and through an order book. Market makers participate in this trading by holding and offering inventory of ETF units. The market maker’s role is very important around launch, to provide the initial bit of trading liquidity before other participants join in over time. There is no involvement in the secondary market of the ETF issuer, just like trading in Google stock doesn’t involve the company. A well-functioning secondary market is an important element of good ETF liquidity.

Comparison between ETFs liquidity and mutual fund liquidity

Mutual fund liquidity is very different to ETF liquidity.

For mutual funds investors transact directly with the fund manager. NAV is calculated once per day and transactions usually happen once a day only. Fund managers have to manage cash required to meet redemptions. Since underlying assets are often sold to raise the cash necessary to pay redeeming mutual fund holders there is a taxable event for all holders of the fund. Mutual funds often take several days to settle and fund managers have leeway to apply premiums and discounts to NAV for flows in a non-transparent way.

ETF liquidity is very different. ETFs trade on a stock exchange so liquidity is available while the market is open, and sometimes pre-market open. The price is on screen throughout the trading session. ETFs are also predominantly transparent meaning holdings and weights are published daily and any participant can calculate NAV. The effective primary market means that any flows in and out of the ETF happen in-kind (i.e. through exchange of shares in the underlying), a non-taxable event for all holders.

Conclusion

ETF liquidity is a very important consideration for investors as it impacts financial return. There are many important factors that drive liquidity. A common misconception is that low AuM and low volume ETFs are illiquid. The unique multiple layers of liquidity, including an effective continuous primary market mean ETFs are a lot more liquid than their onscreen volumes suggest.

FAQ

Why is liquidity important for ETFs?

ETF liquidity matters because it impacts the ability to buy and sell ETFs, and also impacts the return investors make.

What is an ETF?

An ETF (Exchange Traded Fund) is an investment fund that holds assets such as stocks, bonds, or commodities. The fund is traded on a stock exchange and therefore can be conveniently bought or sold like individual stocks. ETFs are more cost-effective and transparent than alternatives like mutual funds and hedge funds. An ETF is also much more tax efficient for the average investor due to their in-kind creation and redemption mechanism. ETFs are therefore a good way to invest, whether it is to diversify one’s portfolio or to gain exposure to a wide range of markets, asset classes and strategies.

 

 

What does it mean when an ETF is liquidated?

This means an ETF is closed down and all funds returned to investors.

What if there is no liquidity in ETF?

Liquidity is measured in many ways. Having no liquidity means you can’t buy or sell the ETF easily.

What are the risks of liquidity in ETF?

Liquidity risk means not being able to sell or buy an ETF at a good price or at all.

What are the three levels of ETF liquidity?

ETF liquidity is provided on the secondary market by investors and market makers. There is also a primary market where new ETF shares can continuously be created or destroyed.