understanding ETFs liquidity

What is ETFs liquidity? All you need to know

ETFs (exchange-traded funds) gives investors access to a diverse portfolio of equities and bonds.  

They’re versatile investment vehicles employed in various ways within a portfolio to fulfill different investment requirements and objectives. ETFs, like stocks, can be traded on an exchange at any time of day. 

An advantage associated with the ETFs compared to their mutual fund counterpart is the liquidity related to the ETFs. ETFs are a substitute for holding several stocks.  

However, unlike stocks, ETFs have a very different connotation associated with liquidity. 

ParameterETFShare
PriceBased on underlying securitiesBased on the supply and demand metrics of the share
SupplyOpen-ended i.e. can be created and redeemed as per needClosed-ended
Primary Source of liquidityLiquidity of underlying securitiesThe trading activity of the shares
The best measure of liquidityThe trading volume of underlying securitiesThe trading volume of share

Two different types of allied ETFs liquidities – Primary and Secondary Liquidity. 

Primary liquidity 

The primary market is where the process of creation and redemption takes place. If a designated broker or market maker sees a demand for a specific ETF, they can issue new units by delivering a basket of assets to the ETF sponsor.  

In exchange, the ETF sponsor provides the market maker with ETF units of equal value, which the market maker subsequently sells publicly on the business to meet investor demand.

In the event of redemption, the process can be reversed when the supply of units exceeds demand.  

The primary market is concerned with the high demand and supply of institutional or non-institutional investors who buy and sell ETF shares in bulk in tandem with the Authorized Participant.  

In the primary market, investors utilize an “authorized participant” (AP) to adjust the supply of ETP shares available either to sell a large basket of shares (“redeem”) or to buy a large basket of shares (“create”). 

Primary Liquidity is the liquidity associated with the ease of creating and redeeming the ETF shares with the help of underlying securities.

The liquidity of the underlying securities plays a significant role in determining the liquidity of the ETF shares in the primary market. 

ETFs liquidity
source: freepik

Secondary liquidity 

Secondary Liquidity is the liquidity associated with the already created ETF shares in the stock market. This liquidity is generally the visible liquidity on the market.  

The non-institutional investors or investors with a smaller scale of operations generally are concerned with this type of liquidity. Investors buy and sell ETF units on the secondary market without the involvement of the ETF issuer.  

Individual investor transactions take place at market prices throughout the trading day. The determinants of the liquidity of the Primary and Secondary Liquidity of ETFs are very different.  

Liquidity in the primary market depends upon the value of the underlying shares that back up the ETF. While liquidity in the secondary market depends upon the weight of ETF shares traded.  

When executing a large trade that runs into thousands of ETF shares, investors can circumvent an illiquid secondary market by directly engaging with the AP to create new shares in the primary market.  

The liquidity of the underlying securities and the liquidity of the ETF in the primary market share a direct relationship. The more efficiently an AP can access the underlying market, the more ETF shares it can create and redeem. 

Unfortunately, most retail or small-scale institutional investors rely on secondary markets for their portfolio allocation. The liquidity in the secondary market can be judged by various statistics such as average spreads, average trading volume, and premiums or discounts, i.e., the value of the ETF (is it near the NAV). 

The volume of an ETF is often seen as a measure of liquidity, which is incorrect. The liquidity of an ETF is influenced by the liquidity of the underlying securities, whereas trading volume is affected by investor activity. 

Suppose an ETF invests in securities with limited supply or that are difficult to trade. In that case, market makers may be unable to create or redeem units of the ETF, affecting the portfolio’s liquidity

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