ETFdb Logo
ETFdb Logo
  • ETF Database
  • Channels
    • Themes
      • Active ETF
      • Artificial Intelligence
      • Beyond Basic Beta
      • China Insights
      • Climate Insights
      • Core Strategies
      • Crypto
      • Direct Indexing
      • Disruptive Technology
      • Energy Infrastructure
      • ETF Building Blocks
      • ETF Investing
      • ETF Education
      • ETF Strategist
      • Financial Literacy
      • Fixed Income
      • Free Cash Flow
      • Innovative ETFs
      • Institutional Income Strategies
      • Leveraged & Inverse
      • Managed Futures
      • Market Insights
      • Modern Alpha
      • Multifactor
      • Responsible Investing
      • Retirement Income
      • Tax Efficient Income
    • Asset Class
      • Equity
        • U.S. Equity
        • Int'l Developed
        • Emerging Market Equities
      • Alternatives
        • Commodities
        • Gold/Silver/Critical Minerals
        • Currency
        • Volatility
      • Fixed Income
        • Investment Grade Corporates
        • US Treasuries & TIPS
        • High Yield Corporates
        • Int'l Fixed Income
    • ETF Ecosystem
    • ETFs in Canada
  • Tools
    • ETF Screener
    • ETF Country Exposure Tool
    • ETF Sector Tracker Tool
    • ETF Database Categories
    • Head-To-Head ETF Comparison Tool
    • ETF Stock Exposure Tool
    • ETF Issuer Fund Flows
    • Indexes
    • Mutual Fund To ETF Converter
  • Research
    • ETF Education
    • Equity Investing
    • Dividend ETFs
    • Leveraged ETFs
    • Inverse ETFs
    • Index Education
    • Index Insights
    • Top ETF Sectors
    • Top ETF Issuers
    • Top ETF Industries
  • Webcasts
  • Themes
    • AI ETFs
    • Blockchain ETFs
    • See all Thematic Investing ETF themes
    • ESG Investing
    • Marijuana ETFs
  • Multimedia
    • ETF 360 Video Series
    • ETF of the Week Podcast
    • ETF Prime Podcast
    • Video
  • Company
    • About VettaFi
    • Get VettaFi’ed
  • PRO
    • Pro Content
    • Pro Tools
    • Advanced
    • FAQ
    • Pricing
    • Free Sign Up
    • Login
  1. ETF Investing
  2. ETF Liquidity 101
ETF Investing
Share

ETF Liquidity 101

Stoyan BojinovJun 24, 2015
2015-06-24

Exchange-traded funds have become extremely popular over the past two decades, as investors have sought easier ways to invest in new markets and asset classes. With over a billion shares per day traded last year, ETFs account for nearly one-third of all dollar volume traded on U.S. exchanges.

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

Why Does Liquidity Matter?

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?


Content continues below advertisement

ETF Liquidity 101

behind the scenes look at gears

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.

What Affects an ETF’s Liquidity?

bull shadow on newspaper

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.

The Bottom Line

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.

» Popular Pages

  • Tickers
  • Articles

Sep 26

Invest for Changing Tides: DBMF Ascends As Equities, Bonds Fall

Sep 26

When Equities Slide, Check Out This Cash Alternative ETF

Sep 26

ETF Prime: Todd Rosenbluth on the SEC “Names Rule”

Sep 26

Government Shutdown May Impact Stocks? Trust Active

Sep 26

TCAF Outperforms SPY Out of the Gate

Sep 26

Investors Can Harvest Losses Even During Up Markets

Sep 26

Main Management Market Note: September 22, 2023

Sep 26

Despite War in Ukraine, Polish Stocks Are Up

Sep 26

The Case for Notable Japan ETF DXJ

Sep 26

Harbor Capital on the Role of Active ETFs This Decade

QQQ

Invesco QQQ Trust Series I

SPY

SPDR S&P 500 ETF Trust

VOO

Vanguard S&P 500 ETF

XLK

Technology Select Sector SPDR...

JEPI

JPMorgan Equity Premium...

SMH

VanEck Semiconductor ETF

TLT

iShares 20+ Year Treasury...

VGT

Vanguard Information...

VTI

Vanguard Total Stock Market...

SCHD

Schwab US Dividend Equity ETF...

Loading Articles...
Our Sites
  • VettaFi
  • Advisor Perspectives
  • ETF Trends
Tools
  • ETF Screener
  • Mutual Fund to ETF Converter
  • Head-To-Head ETF Comparison
  • ETF Country Exposure Tool
  • ETF Stock Exposure Tool
  • ETF Database Pro
More Tools
  • Financial Advisor & RIA Center
Explore ETFs
  • ETF News
  • ETF Category Reports
  • Premium Articles
  • Alphabetical Listing of ETFs
  • Browse ETFs by ETF Database Category
  • Browse ETFs by Index
  • Browse ETFs by Issuer
  • Compare ETFs
Information
  • Contact Us
  • Terms of Use and Privacy Policy
  • © 2023 VettaFi LLC. All rights reserved.

Advertisement

Is Your Portfolio Positioned With Enough Global Exposure?

ETF Education Channel

How to Allocate Commodities in Portfolios

Tom LydonApr 26, 2022
2022-04-26

A long-running debate in asset allocation circles is how much of a portfolio an investor should...

Core Strategies Channel

Why ETFs Experience Limit Up/Down Protections

Karrie GordonMay 13, 2022
2022-05-13

In a digital age where information moves in milliseconds and millions of participants can transact...

}
X