ETFs: Three Levels of Liquidity for Greater Access to the Market
Although Exchange Traded Fund (ETF) liquidity can seem complex, here, we explore the various sources of liquidity for ETFs, which contain a portfolio of securities and trade throughout the day like stocks.
Trading Volume Does Not Equal Liquidity
For a stock, the average daily volume (ADV) has always been a strong indicator of liquidity, or the degree to which stocks can be bought or sold in the market without affecting their price. When looking at ETFs, ADV is a partial indication of an ETF’s liquidity. That’s because, unlike stocks that have a set number of shares, new ETF shares can be created and existing shares can be redeemed based on investor demand. ETFs have different layers of liquidity that allow investors to trade ETFs in amounts that can far exceed an ETF’s ADV without significantly affecting the ETF’s price.
Three Sources of ETF Liquidity
There are three levels of liquidity to consider for ETFs: on-screen liquidity, nondisplayed liquidity and liquidity from the underlying ETF basket of securities.
1. Liquidity Visible to the End Investor
The most visible source of ETF liquidity is on-screen liquidity, which the average investor has access to via a variety of sources such as a brokerage house. This level of liquidity represents the trading activity that has already occurred on the exchange and is visible in the secondary market, where ETFs are priced and traded like stocks. A market maker publishes quotes that represent the price of available ETF shares they are willing to buy and sell. Investors bargain with other investors as well as market makers who help maintain a fair and orderly market. Market makers are always ready to buy available ETF shares from potential sellers and sell ETF shares to potential buyers.
Typically, there are two prices for an ETF visible to the public: the price at which someone is willing to purchase the ETF (known as the bid) and the price at which someone is willing to sell the ETF (known as the offer or ask). The difference between the two prices is called the spread. Because ETFs hold multiple securities in the underlying basket, the spread of all the securities influences the total spread of the ETF.
2. Liquidity Accessed via Your Broker
As a typical investor, your on-screen view of liquidity is limited on public financial websites. Most often, you will have access only to the highest bid and lowest offer, but you won’t see all quotes in an ETF’s order book on the stock exchange. You may access this level of liquidity with the assistance of a broker. The broker can see additional levels of quotes that represent additional prices at which ETFs can be traded.
For most ETFs, market makers will publish quotes beyond the visible liquidity, helping to provide market depth. They do this so that larger-size trades may be executed while covering their costs of providing liquidity. You can access this liquidity by providing a limit order to your broker to buy or sell ETF shares at a price beyond the on-screen liquidity. Or, you can contact your broker’s ETF block desk, which handles large purchases and sales of ETF shares.
3. Liquidity Access by Specialists
The bulk of ETF liquidity is in the primary market, where the ETF accesses the underlying securities it holds. Here, the creation and redemption mechanism, which is an important process for ETFs, comes into play.
When buying or selling a large number of ETF shares—on the scale of thousands—you can reach out to large institutions that act as authorized participants to create and redeem large blocks of ETF shares directly from the ETF provider or its custodian.
The Creation and Redemption Process Ensures ETFs Liquidity
The creation and redemption process ensures there is sufficient inventory to fill investors’ orders. It allows large buy or sell trades to be executed in the ETF with little or no impact to the market.
For an ETF share creation, the authorized participant assembles a portfolio or basket containing the ETF's underlying securities. The authorized participant turns the basket over to the ETF custodian, who holds all the securities in the ETF. In return, the custodian delivers ETF shares that can be bought and sold in secondary markets. This is generally done in blocks of 25,000, 50,000 or 100,000 ETF shares.
The ETF creation/redemption process occurs when an investor enters an order to buy/sell a large number of ETF shares and there are not enough shares available on the secondary market.
ETF share redemption reverses this process when excess supply of ETF shares needs to be removed from the market. The process helps keep supply and demand in balance and leads to an ETF share price that is generally in line with the value of the underlying securities. These shares are used to fill investors' trades in the secondary market.
Learn More About the Tools of the ETF Trade
This article has provided a short overview of the layers of liquidity for an ETF. For a deeper dive, read our thought leadership paper, Tools of the ETF Trade: Understanding ETF Liquidity and Trading (requires login). You'll learn about:
The different sources of ETF liquidity
Trading execution considerations
Tips and best practices for trading ETFs
Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.