ETF Liquidity: What It Is and Why It Matters (2024)

Liquidity is one of the most important features of exchange-traded funds (ETFs), though frequently misunderstood. An ETF's liquidity refers to how easily shares can be bought and sold without impacting the ETF's market price. In other words, a highly liquid ETF allows for swift transactions at prices that closely reflect the intrinsic value of the underlying assets, ensuring that investors can easily enter or exit positions without encountering significant price discrepancies or incurring high trading costs. An ETF's liquidity is crucial because it impacts trading costs and helps determine how closely the ETF's price tracks its underlying assets.

Read on to understand how ETF liquidity works and what it means for traders and investors.

Key Takeaways

Exchange-traded funds (ETFs) have higher liquidity than mutual funds, making them popular investment vehicles and convenient to tap into when cash flow is needed.
The primary factors that influence an ETF’s liquidity are its composition and the trading volume of the securities that make it up.
The secondary factors that influence an ETF’s liquidity include its trading volume and the investment environment.
Low-volume ETFs do not necessarily have low liquidity.

What Is Liquidity?

The concept of liquidity in ETFs extends beyond the traditional understanding applied to individual stocks. It is a multitiered framework involving both the dealer and secondary markets. In the primary or dealer market, liquidity is facilitated through the creation and redemption mechanisms. This unique process allows for adjusting the ETF's supply to meet investor demand, maintaining price stability. In the secondary market (i.e., the stock market), liquidity is described through the trading volume of the underlying securities in the ETF and their bid-ask spread. A narrower spread frequently signifies higher liquidity and lower trading costs.

Liquidity describes how easily an investment can be converted into cash. A highly liquid asset can be bought and sold quickly, in large amounts, and without significantly impacting its market price. Less liquid assets may take longer to sell or require accepting a discounted price.

Liquidity Indicators

Two primary indicators of liquidity are the following:

An asset’s trading volume: Higher trading volume frequently correlates with greater liquidity because more buyers and sellers in the market mean that transactions can likely be completed more easily.
The bid-ask spread: This is the difference between the highest price a buyer is willing to pay for an asset (the bid) and the lowest price a seller is willing to accept (the ask or offer). A narrower bid-ask spread frequently signifies higher liquidity.

Consider a hypothetical stock for XYZ, Inc. In one situation, it has a high trading volume and a tight bid-ask spread of $0.02, indicating high liquidity, which means shares can be easily bought or sold without significantly affecting the price. Alternatively, a stock for ABC, Inc. has a low trading volume and a wide bid-ask spread of $2, indicating low liquidity. Here, buying or selling ABC shares would not receive prices as favorable, and trading large amounts could noticeably change the price. Through this simplified example, it’s evident how liquidity impacts the ease of trading and the stability of the market price, highlighting its importance in investment decisions.

The “secondary market” liquidity seen on exchanges is important for ETF investors and traders. However, unlike stocks, ETFs possess another layer of liquidity considerations because of how they are created.

ETF Primary Market Liquidity

ETFs rely on a unique creation and redemption mechanism that provides primary market liquidity. Authorized participants (APs) can create or redeem ETFs and exchange the “baskets” of the ETF’s underlying securities for new ETF shares from the fund issuer.

Many ETFs are open-ended funds, meaning they can continuously adapt the number of outstanding shares. Unlike closed-end funds, which have a fixed number of shares, open-ended ETFs can adjust their share count based on demand and supply dynamics.

NAV

Net asset value (NAV) is a critical concept for ETFs and mutual funds. It represents the per-share market value of all its securities. To calculate the NAV, the total value of the fund's assets is determined, any liabilities are subtracted, and the remaining number is divided by the total number of outstanding shares of the fund. The formula is as follows:

NAV = (Total Value of Portfolio Assets - Total Value of Liabilities)/Total # Outstanding Shares

NAV provides a gauge of what an ETF or mutual fund's share is worth intrinsically, making it a fundamental metric for fund investors.

ETF Creation Process

Basket assembly: The process begins with an AP assembling a “basket” of the ETF’s underlying securities. This basket mirrors the exact composition and proportion of assets held within the ETF. For example, an ETF that tracks the Dow Jones Industrial Average would hold the 30 stocks that comprise the Dow in their appropriate weightings.
Exchange with the issuer: The AP then exchanges this basket of securities with the ETF issuer. In return, the issuer provides the AP with new ETF shares equivalent to the basket’s value based on the ETF’s net asset value, or NAV.
Secondary market supply: The new ETF shares are now available for trading in the secondary market, where investors can buy or sell them just like regular stocks on exchanges. This process helps ensure that the supply of ETF shares in the market meets demand, keeping the ETF’s market price in alignment with its NAV.

ETF Redemption Process

Redemptions work in reverse: APs exchange ETF shares back to the issuer in exchange for the underlying basket of securities. This flexibility allows supply to adjust quickly to meet demand.

ETF share accumulation: When there's a need to decrease the supply of ETF shares in the market, an AP buys the required number of ETF shares in the secondary market.
Exchange with the issuer: The AP returns these ETF shares to the issuer. In exchange, the issuer provides the AP with a basket of the underlying securities equivalent to the NAV of the ETF shares.
Adjustment of supply: This redemption process reduces the number of ETF shares available in the market, aligning the supply with the prevailing demand.

Example of Creation and Redemption Affecting Liquidity

Suppose a firm named GreenTech ETF tracks the clean technology sector. One day, a breakthrough invention in solar energy creates waves of excitement in the market. Investors move to buy shares of GreenTech ETF to capitalize on this trend. The sudden surge in demand could drive the share price of the ETF sky-high, deviating from the actual value of the underlying assets or its NAV. This is where the creation process kicks in.

APs, which can create and redeem ETF shares, notice this demand spike. An AP assembles a basket of the underlying clean tech stocks that GreenTech ETF tracks and exchanges it with the ETF issuer for new shares of GreenTech ETF. These new shares are then introduced in the market, increasing the supply to meet the burgeoning demand. This helps keep the price of GreenTech ETF in check, ensuring its price is closely aligned with the NAV.

Let's move ahead a few weeks. Suppose the market cools down, and investors decide to sell their shares of GreenTech ETF. The increased selling pressure could drive the price of the ETF shares well below the NAV. This is where the redemption process comes into play. An AP buys the ETF shares from the market and returns them to the ETF issuer. The AP receives a basket of the underlying clean tech stocks in exchange. This process helps to absorb the excess supply of ETF shares in the market, supporting the ETF's price and preventing it from plummeting.

The liquidity of GreenTech ETF is managed through these creation and redemption mechanisms, which help ensure that investors can buy or sell shares at prices representing the value of the underlying assets. These mechanisms adjust supply to meet demand and help maintain the ETF's price stability and liquidity, which are crucial for an efficient trading experience and fair asset valuation for investors.

How Liquidity of Underlying Assets Affects Creations and Redemptions

Consider again our GreenTech ETF example. The ease investors have trading shares in this ETF is considerably affected by the liquidity of the individual stocks it holds. Here’s how: The creation and redemption process involves exchanging baskets of the ETF’s underlying securities for ETF shares and vice versa. If the underlying securities in the GreenTech ETF are highly liquid—they can be easily bought and sold in the market—the APs can promptly assemble or disassemble the required baskets for creation or redemption. This fluidity in the primary market translates to higher liquidity in the secondary market, where investors trade ETF shares.

Conversely, if some or all the underlying stocks are illiquid—they are hard to buy or sell without significantly affecting the price—the APs might face challenges in assembling or disassembling the baskets quickly. This delay could affect the timeliness and efficiency of the creation and redemption process, affecting the liquidity of the GreenTech ETF.

When investors want to sell their GreenTech ETF shares, a fluid redemption process supported by the liquidity of the underlying holdings helps ensure that the excess supply of ETF shares is efficiently absorbed. This helps maintain a stable price in GreenTech ETF shares.

In essence, the liquidity of the underlying holdings of an ETF directly impacts the ETF’s liquidity. A well-structured ETF with liquid underlying assets can better adapt to market demand changes, preserving fair prices and an efficient investor trading experience.

Generally, ETFs that invest in large-cap, domestically traded companies are the most liquid, as these shares tend to be the most liquid.

ETFs that invest in less liquid securities, such as real estate or assets from emerging markets, tend to have less liquidity.

ETF Secondary Market Liquidity

Secondary market liquidity is the ease with which investors can buy or sell ETF shares on exchanges, much like individual stocks. This liquidity is visible through metrics such as trading volume, market depth, and the bid-ask spread. High trading volumes and narrow bid-ask spreads frequently signify good liquidity, making it easier and cost-effective for investors to trade.

However, many factors can affect ETF secondary market liquidity. Consider spot Bitcoin ETFs, which were approved by the U.S. Securities and Exchange Commission Jan. 10, 2024. Although these ETFs saw a great deal of interest in the first days of trading, the relatively new cryptocurrency market means that their liquidity may not be deep enough to allow traders to move as easily into and out of positions as they could with other ETFs.

Diverging Liquidity Among Similar ETFs

Liquidity can vary significantly even among ETFs that track the same index. For example, several ETFs track the . Despite it being the same index, these ETFs frequently exhibit varying levels of liquidity for several reasons:

Trading volume: ETFs with higher trading volumes may have greater liquidity, though not necessarily. More active trading can lead to narrower bid-ask spreads, reducing the cost of trading. For instance, an ETF like (SPY) might have higher trading volumes and, therefore, better liquidity than a less traded S&P 500 ETF.
Fund size: Larger funds frequently have greater liquidity. The fund size can impact how efficiently the APs carry out the creation and redemption process, influencing the secondary market's liquidity.
Fund sponsor: Established fund sponsors or issuers with good reputations could attract more investors, increasing the trading volume in their ETFs. Their experience and investor trust can thus lead to greater liquidity.
Market making: Efficient market making is crucial for liquidity. Market makers ensure there's a buyer for every seller and vice versa. ETFs with robust market-making support tend to have better liquidity. ETFs with fewer active market makers frequently have lower liquidity.
Expense ratio: ETFs with lower expense ratios may attract more investors, potentially leading to higher trading volumes and better liquidity.

Example of Liquidity Differences With Similar Underlying Assets

Consider two hypothetical ETFs: Alpha S&P 500 ETF and Beta S&P 500 ETF, both tracking the S&P 500. Alpha ETF, managed by a respected sponsor, has a lower expense ratio and has attracted many investors and market makers, resulting in higher trading volumes and a narrower bid-ask spread. Alternatively, Beta ETF has a higher expense ratio and is managed by a lesser-known sponsor. This results in lower trading volumes, fewer market makers, and a wider bid-ask spread.

The profiles of these two similar ETFs can lead to different relative levels of liquidity. Investors might find it easier and more cost-effective to trade shares of Alpha ETF than Beta ETF, despite both ETFs tracking the same index.

By daily trading volume, the S&P 500 SPDR (SPY), Invesco QQQ (QQQ), and Financial Select Sector SPDR (XLF) tend to be among the most active ETFs.

Major Players Involved in ETF Liquidity

The liquidity of ETFs is a collaboration involving various market players, each with a significant role. Here are some of the major liquidity players in the ETF market:

APs: They are at the core of the ETF liquidity mechanism, given their unique ability to create and redeem ETF shares directly with the ETF issuer, thus helping adjust the ETF's share supply to meet market demand.
ETF issuers: They are responsible for the initial creation of ETFs and manage the underlying assets. By structuring and managing ETFs, issuers, also called sponsors, play a vital role with APs in helping ETFs remain liquid and trade in alignment with their NAV.
Market makers: Market makers contribute to ETF liquidity by continually offering to buy and sell ETF shares at publicly quoted prices. They help to narrow the bid-ask spread, which improves liquidity.
Exchanges: Exchanges provide the platform for buying and selling ETF shares, and their operational efficiency affects how easily trades can be executed. ETFs listed on several major exchanges will be more accessible to more investors.
Investors and traders: Both institutional and retail investors contribute to ETF liquidity through their trading activities. Their demand for ETF shares affects trading volumes, which, in turn, impacts liquidity.

Brokers and dealers: Brokers and dealers enable the trading of ETF shares on behalf of investors. Their understanding of market dynamics and ability to execute trades efficiently can influence ETF liquidity.
Custodian banks: These hold the ETF's assets on behalf of issuers, handle the settlement of trades, and perform other key operational duties to help maintain the smooth functioning of ETFs, which in turn supports liquidity.
Clearing houses: Clearing houses ensure that trades are timely and settled correctly, which is essential for maintaining trust and liquidity in the ETF market.

Each of these players has a distinct role, and their collective actions contribute to the liquidity and overall efficiency of the ETF market.

5 Misconceptions About ETF Liquidity

1. High Trading Volume Equals High Liquidity

While trading volume can indicate liquidity, it's not the whole story. An ETF can have good liquidity even with lower trading volumes because of the creation and redemption mechanisms. If creations and redemptions are easily facilitated, the actual trading volume in the ETF may not matter as much. Alternatively, even if an ETF has a high trading volume and a lot of interest, but the underlying shares are illiquid, APs may find engaging in creations and redemptions difficult.

2. Small Assets Under Management Signify Low Liquidity

The size of an ETF measured by its assets under management (AUM) likewise doesn’t necessarily dictate its liquidity. Even ETFs with smaller AUM can have high liquidity if they track a liquid index or sector and have active APs facilitating the creation and redemption process.

3. Secondary Market Liquidity Is the Total Liquidity

Secondary market liquidity, reflected by the bid-ask spread and trading volume on trading platforms, only indicates the liquidity in the secondary market. However, the total liquidity of an ETF also includes the primary market liquidity that the APs facilitate. The creation and redemption process can considerably increase an ETF's liquidity beyond what's visible on the screen.

4. All ETFs Tracking the Same Index Have Similar Liquidity

Liquidity can vary among ETFs even if they track the same index. Factors such as fund size, market making, fund sponsor reputation, and the expense ratio can influence an ETF's liquidity profile.

5. ETFs with Wider Bid-Ask Spreads are Less Liquid

While a narrower bid-ask spread frequently suggests better liquidity, a wider spread isn’t always a sign of poor liquidity. The spread can be influenced by the liquidity of the underlying assets and the efficiency of the market-making process. It’s essential to consider the overall liquidity profile, including primary and secondary market liquidity, rather than relying exclusively on the bid-ask spread.

Why Is ETF Liquidity Important?

Investors and traders in any security benefit from greater liquidity—that is, the ability to quickly and efficiently sell an asset for cash. Investors who hold ETFs that are not liquid may have trouble selling them at the price they want or in the time frame necessary. Moreover, if an ETF invests in illiquid shares or uses leverage, the market price of the ETF may fall dramatically below the fund’s NAV.

How Does the Choice of Index or Sector Tracked by an ETF Impact Its Liquidity?

The choice of the index or sector tracked by an ETF can significantly affect its liquidity. If an ETF tracks a well-known, widely followed index with liquid underlying assets, it's likely to have better liquidity. Conversely, ETFs tracking obscure or less liquid indexes may face liquidity challenges, as the underlying assets might be harder to trade, affecting the efficiency of the creation and redemption process.

Can the Time of Day Affect ETF Liquidity?

Yes, as with stocks, the time of day can affect ETF liquidity. Typically, liquidity is higher during the market's opening and closing, known as the market's “rush hours,” because of higher trading volumes. During off-peak hours, for example, around lunchtime, liquidity may diminish, potentially leading to wider bid-ask spreads and less favorable prices for investors.

Is the Liquidity of ETFs and Mutual Funds Comparable?

Not exactly. ETFs and mutual funds have different liquidity profiles. Unlike ETFs, which are traded on exchanges like stocks, mutual fund shares are bought and sold directly with the fund at the day's closing NAV. The real-time trading feature of ETFs provides intraday liquidity, allowing investors to execute trades throughout the trading day. Alternatively, mutual funds offer end-of-day liquidity, with all orders processed at the closing NAV. This basic difference makes the liquidity experience between ETFs and mutual funds distinct, catering to different investor preferences and strategies.

Can Ordinary Investors Create and Redeem ETF Shares?

No, only APs are allowed to transact directly with the ETF issuer to create and redeem shares. Retail investors can only buy or sell ETF shares on a secondary market exchange.

The Bottom Line

ETF liquidity is based on the dynamics in the dealer and secondary markets. Dealers acting as APs can create and redeem ETF shares to meet supply and demand changes in the ETF and keep its market price in line with its NAV. On the secondary market, ETF shares with higher trading volume and tighter spreads are usually more liquid.

As with any financial security, not all ETFs have the same level of liquidity. An ETF’s liquidity is affected by the securities that it holds, the trading volume of the securities held, the trading volume of the ETF itself, and the investment environment. Understanding how these factors affect an ETF’s liquidity and, therefore, how its profitability will improve results is especially important in environments where every cent counts.