ETF Liquidity: More than Meets the Eye

Journal of Financial Planning: October 2015


Tom Lydon is editor of and president of Global Trends Investments, a registered investment adviser. He is a frequent contributor to major print, radio, and television media.

Advisers and investors have certain notions on the ability to execute an optimal trade based on the perceived liquidity of traditional stocks. However, with issues of liquidity, what has been used to determine a stock’s liquidity cannot be necessarily applied to ETFs.

True liquidity of ETFs could be better interpreted as a combination of the ETF’s average daily trading volume and the average daily trading volume of the underlying securities. ETF liquidity has to do with what is inside the index that the ETF is based upon.

There’s a misconception that ETFs with high trading volumes are liquid, while those with low trading volumes are illiquid. If traded properly, buy and sell orders should have around the same price impact in percentage terms in all products, although bid/ask spreads will be wider from one ETF to another. But no one said you have to trade with the visible bid/ask spreads.

ETFs trade in two distinct markets. The secondary market refers to the on-screen, quotable market that we track through price changes on the stock exchange. The primary market is where authorized participants (APs) and the ETF sponsor help create and redeem ETF shares for underlying securities or holdings, which occur at the net asset value (NAV) of the ETF, through so-called in-kind transactions.

The creation and redemption process helps keep an ETF trading near its NAV and allows large traders to go in and out of what appears to be an ETF with low liquidity. For instance, if an adviser or investor wants to take a large order on an ETF that only trades on a couple thousand shares per day, he or she would contact an AP. The AP would come back with a quote, and the investor would pay the broker the necessary commission. Behind the scenes, the AP would tap into the underlying benchmark to acquire the necessary liquidity to back the large ETF trade. APs or institutional investors would swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa.

If demand for an ETF outstrips supply, the AP would borrow shares of stock from an underlying benchmark and put them in a trust to form a so-called creation unit of an ETF. The trust provides shares of the ETF that are legal claims on the shares held in the ETF, and the AP exchanges the basket of stocks for ETF shares, which are sold to the public on the secondary market.

Once demand for an ETF reaches about 50,000 shares, a liquidity provider can put in an order for a unit to an AP who will go to the ETF issuer to exchange the in-kind portfolio of component securities for a creation unit of the ETF. Conversely, ETF shares can be exchanged for a basket of securities from the underlying benchmark.

For sell orders, the liquidity provider buys ETFs from the public and sells short the basket of underlying securities. If enough orders are processed to hit a creation unit, the liquidity provider can submit an order to redeem his or her position of 50,000 shares in an ETF through an AP.

Fixed-income investors are concerned that some bond ETFs could come against liquidity concerns if the Federal Reserve were to hike rates and spark a major sell-off in debt securities. The fixed-income market has been known for its illiquid nature, but as bond ETFs have grown in size, more institutional investors have turned to ETFs to easily enter and exit fixed-income positions. But in recent bond market corrections, segments of the junk bond market exhibited a widening gap between the NAV and ETF share prices, diminishing returns for sellers.

On the execution side of ETFs, advisers should look at how to make the market in the ETFs, patiently wait for orders to get filled, or look to have someone execute the order in the underlying security. An ETF faux pas is using market orders, because it leaves a trader open to sudden price spikes that can trigger an unwanted price change. It’s more prudent to use limit orders to better control trades.

When an ETF is trading at low volumes, it doesn’t mean there is low liquidity. There is a lot of liquidity in the underlying baskets, but one needs to be able to successfully access it. Liquidity represents the number of shares that can be traded in the underlying security. So, it is possible to shift around large quantities of cash in low-volume ETFs, but an investor needs to be more creative in the process.

Investment Planning