Exchange traded funds are often valued for their tax efficiency and cost savings, but a somewhat overlooked benefit to an ETF over another fund type is liquidity, which works differently for an ETF than for a standard stock or mutual fund.
ETFs are generally considered to be more liquid than their mutual fund counterparts because they trade on an exchange like a standard stock at any point in the day, whereas mutual funds are typically locked into trades once a day at market close. ETFs are not standard stocks, however, and therefore carry two different types of liquidity.
As with a standard share, the average daily volume (ADV) of trading matters, as it indicates demand for shares by investors, but it only tells part of the liquidity story of an ETF. Unlike a share, the supply for ETF shares is open-ended due to the creation and redemption mechanism that ETFs utilize. An ETF is comprised of a portfolio of securities, and it is from these underlying securities that it gains its primary liquidity via creation and redemption.
In order to execute a creation and redemption cycle, the liquidity of the portfolio is relied upon to create new blocks of ETF shares through an authorized participant (AP). The AP creates or redeems blocks of shares from the ETF issuer or manager, and it is through this process that the supply is regulated and investors are able to execute buy and sell orders that might extend beyond the ADV.
Active portfolio managers can move within markets quickly and easily, gauging the liquidity of the securities and responding to market conditions to optimize the portfolio and its liquidity. An ETF is typically the most price-efficient option within markets that have a lot of trading volume, as the price spread tends to be narrowest and the transaction costs are typically less. An active manager works to balance all of these components when optimizing their active ETFs.
Investors and advisors need to take into account both levels of liquidity when looking to invest in an ETF, which requires research and an understanding of underlying markets, the securities within the ETF, current market conditions, and anticipated conditions when looking ahead.
Active management firm T. Rowe Price eight different actively managed ETFs, many of which trade in high-volume markets, allowing the experienced portfolio manager to optimize the liquidity in a variety of market conditions.
The firm brings a bevy of research and experience to its products, with portfolio managers averaging over 20 years in investing each, as well as over 400 investment professionals dedicated to researching companies within ETFs.
For more news, information, and strategy, visit the Active ETF Channel.