In this article, we’ll take a look at the role liquidity plays and some things investors should consider.

Liquidity is the degree to which a security can be purchased or sold on the market without affecting its market price. Since an investor can quickly exit in the event of a problem, liquid securities with high trading volumes are preferable over illiquid securities with low trading volume. The risks associated with liquidity are known as “liquidity risks” and can be quantified by looking at metrics such as average daily dollar volume, and the bid/ask spread.

ETFs face two liquidity concerns that investors should be aware of: primary market liquidity and secondary market liquidity. Primary market liquidity refers to the ETF’s ability to keep its discounts/premiums to net asset value at a minimum, while secondary market liquidity refers to the spread and shares available between the bid/ask price. Investors should be aware of both of these liquidity concerns before investing in less liquid ETFs.

If you haven’t already, be sure to read What Is An ETF?

Most investors have traded ETFs on the secondary market by buying and selling them through a brokerage account like TD Ameritrade. However, the actual creation and redemption of ETFs takes place on the primary market between the ETF and authorized participants. By continuously creating and redeeming shares, these authorized participants meet the supply and demand needs of investors on the secondary markets where they actually trade.

Authorized participants create new ETF shares by acquiring the securities that make up the benchmark fund and then exchanging those securities for cash or ETF shares that it can then sell in the secondary market to individual investors. Conversely, authorized participants can redeem ETF shares in large increments in exchange for the underlying securities, or cash, in the appropriate weightings and amounts.

See also 10 Questions About ETFs You’ve Been Too Afraid To Ask.

The purpose of these transactions is to create liquidity in the primary market and ensure that the ETF’s price very closely reflects the price of its underlying assets (via arbitrage opportunities). For example, if the price of an ETF became cheaper than the sum of its parts, the authorized participant could redeem the ETF and sell the components at a profit. Low levels of liquidity in this market could create premiums and discounts to the ETF’s net asset value.

The secondary market’s liquidity, by contrast, is the degree to which the ETFs themselves trade on stock exchanges without affecting the market price. Liquidity in the secondary market ensures that an individual investor can purchase an ETF at roughly the same price they can sell it for (a tight spread), while ensuring that there’s always somebody willing to take the other end of the trade (market makers), even when larger share amounts are involved.

There are many different factors that influence an ETF’s liquidity in both of these markets. In the primary market, the liquidity of the individual components makes the difference. Authorized participants that are unable to purchase the components cannot efficiently create ETFs, while illiquid prices of the components might make redeeming the ETFs less attractive. After all, liquidity risks must be discounted in any illiquid security’s valuation due to slippage.

The liquidity of these component stocks can depend on any number of factors, including the asset class, foreign market exposure, market capitalization, and market makers. For example, a micro-cap stock trading on a foreign stock exchange may trade only 10,000 shares per day, which would make it difficult for a large authorized participant to acquire the stock without moving the market price higher if he/she needs 10,000 or 100,000 shares.

In the secondary market, ETF liquidity is most affected by market makers that are responsible for “making a market” for the security. These institutions make money from the difference in the bid/ask spread by selling at the bid price and buying at the ask price. ETFs with a lot of demand from individual investors and institutions attract more market makers due to the higher volumes, thereby increasing competition, tightening the spreads, and improving liquidity.

See also the 25 Things Every Financial Advisor Should Know About ETFs.

ETFs have become enormously popular among individual investors, but there are many risks to consider when buying or selling them. Liquidity can limit an investor’s ability to buy and sell without influencing the market price in an unfavorable way. In general, individual investors should stick to larger ETFs with high trading volumes and tight spreads to minimize their risk, while also making sure that the ETF’s holdings aren’t obscure or illiquid securities.

Disclosure: No positions at time of writing.