Etfs: A Liquid Investment Option?

Exchange-traded funds (ETFs) are a popular investment vehicle due to their liquidity, which allows investors to easily enter or exit positions without encountering significant price discrepancies or high trading costs. ETFs have two layers of liquidity: the primary market, which is tied to the value of the underlying securities, and the secondary market, which is related to the value of the ETF shares traded. The primary market involves the creation and redemption of ETF shares, while the secondary market is where most investors trade. While the factors determining liquidity differ between the two markets, both contribute to the overall liquidity of ETFs and ensure the orderly trading of these investment vehicles.

Liquidity in the primary market

In the primary market, a specific type of entity known as an "authorised participant" (AP) can change the supply of ETF shares available. An AP can offload a large basket of shares (redeem) or acquire a large basket of shares (create) directly from the ETF issuer. Typically, the AP is doing business in the primary market to meet supply and demand imbalances from the trading that happens in the secondary market. Ultimately, the primary market helps provide additional liquidity in the secondary market.

The creation and redemption process occurs in the primary market. If there is demand for a particular ETF, a designated broker or market maker can create new units by delivering a basket of securities to an ETF sponsor. In return, the ETF sponsor delivers ETF units of equal value to the market maker, which the market maker then sells publicly on the exchange to meet investor demand. The reverse process is followed in the case of redemptions, when the supply of units is larger than the demand.

The determinants of primary market liquidity are different from those of the secondary market. In the secondary market, liquidity is generally a function of the value of ETF shares traded; in the primary market, liquidity is more a function of the value of the underlying shares that back the ETF.

Liquidity in the secondary market

The secondary market is where most investors trade ETF shares. It is the market in which ETF shares or common shares of public companies that currently exist are traded on exchanges between investors.

The liquidity in the secondary market is determined primarily by the volume of ETF shares traded. This is also known as the "on-screen" liquidity, which is visible through metrics such as trading volume, market depth, and the bid-ask spread. High trading volumes and narrow bid-ask spreads often indicate good liquidity, making it easier and more cost-effective for investors to trade.

However, it is important to note that low trading volume does not necessarily equate to low liquidity. The liquidity of an ETF's underlying securities also plays a crucial role in determining the overall liquidity of the ETF. If an ETF invests in securities with limited supply or those that are difficult to trade, it may impact market makers' ability to create or redeem ETF units, affecting the portfolio's liquidity.

To assess the liquidity in the secondary market, it is recommended to follow an ETF at different times of the day and over various time periods, noting how it is affected by different market environments. Some key statistics to focus on include average bid-ask spreads, average trading volume, and premiums or discounts (i.e., whether the ETF trades close to its net asset value).

While the secondary market is where most non-institutional investors trade, it is worth mentioning that for large trades involving tens of thousands of shares, investors may be able to utilise the primary market by working with an "authorised participant" (AP) to create or redeem a large basket of shares.

How to evaluate ETF liquidity

Liquidity is one of the most important features of exchange-traded funds (ETFs), but it is often misunderstood. ETF liquidity has two components: the volume of units traded on an exchange, and the liquidity of the individual securities in the ETF's portfolio.

When evaluating the liquidity of an ETF, consider the following:

• Trading volume: The number of shares traded per day. Generally, the higher the trading volume, the better the liquidity. However, it's important to note that low-volume ETFs do not necessarily have low liquidity.
• Bid-ask spread: The difference between the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask). A narrower bid-ask spread indicates higher liquidity and lower trading costs.
• Market impact: The effect of a large order on the price of a security. If you try to buy a large number of shares, you may have to pay a higher price, driving up the market price.
• Underlying securities: The liquidity of the individual stocks or assets that the ETF holds. If the underlying securities are highly liquid, it will be easier for authorised participants (APs) to create or redeem ETF shares to meet demand.
• Fund size: Larger funds tend to have greater liquidity as they attract more trading volume.
• Fund sponsor: Established fund sponsors with good reputations may attract more investors, increasing trading volume and liquidity.
• Market-making: Efficient market-making ensures there is a buyer for every seller and vice versa. ETFs with robust market-making support tend to have better liquidity.
• Expense ratio: ETFs with lower expense ratios may attract more investors, leading to higher trading volumes and better liquidity.

It's important to remember that not all ETFs have the same level of liquidity, and factors such as the time of day can also affect liquidity. Additionally, the total liquidity of an ETF includes both primary market liquidity (the creation and redemption of shares by APs) and secondary market liquidity (trading volume and bid-ask spread on exchanges).

The role of authorised participants

Authorised Participants (APs) are the capital market's facilitators of the ETF creation and redemption process. They are responsible for creating and redeeming ETFs, and their role is critical in enabling the ETF wrapper to trade as efficiently as possible.

If an investor owns shares in an ETF, they can be sold on the stock market to another investor. This is the role of market makers. However, if an investor wants to sell their ETF shares and there is no buyer, APs can go into the primary market to create more ETF shares. Conversely, if there is an excess supply of ETF shares on the market, APs can reduce this number by delivering the shares to the issuer in exchange for the underlying securities.

This creation-redemption process helps keep ETFs priced at their fair value, typically the net asset value (NAV). For example, if demand for an ETF increases and a premium to NAV develops, APs step in to create more shares and push the ETF's price in line with the NAV. If an ETF is being sold and a discount develops, APs purchase ETF shares on the open market and redeem them with the ETF issuers to reduce supply.

In order to act as a middleman in this capacity, an AP must, in most cases, be a licensed broker-dealer and be able to clear securities with the Depository Trust & Clearing Corporation (DTCC). The DTCC acts as an additional layer of protection to guarantee the transaction.

The more APs pricing an ETF, the better, as this competition is more likely to keep the ETF trading close to its fair value. This method of creation and redemption is the biggest difference between ETFs and mutual funds or investment trusts.

The impact of liquidity on trading costs

Liquidity is one of the most important features of exchange-traded funds (ETFs) and impacts trading costs. It refers to how easily shares can be bought and sold without affecting the ETF's market price. A highly liquid ETF allows for swift transactions at prices that closely reflect the intrinsic value of the underlying assets, ensuring that investors can enter or exit positions without significant price discrepancies or high trading costs.

The primary factors influencing an ETF's liquidity are its composition and the trading volume of its constituent securities. The secondary factors include the ETF's own trading volume and the investment environment. It's important to note that low-volume ETFs do not necessarily have low liquidity.

The concept of liquidity in ETFs goes beyond the traditional understanding of individual stocks. It involves both the dealer and secondary markets, creating a multitiered framework. In the primary or dealer market, liquidity is facilitated through creation and redemption mechanisms, allowing adjustment of the ETF's supply to meet investor demand and maintain price stability. In the secondary market, liquidity is described by the trading volume of the underlying securities in the ETF and their bid-ask spread. A narrower spread often indicates higher liquidity and lower trading costs.

The daily volume traded of an ETF is often incorrectly used as a reference point for liquidity. An ETF's liquidity is determined by the liquidity of its underlying securities, while trading volume is influenced by investor activity. If an ETF invests in securities with limited supply or difficult trading conditions, it may impact market makers' ability to create or redeem ETF units, affecting the portfolio's liquidity.

To understand ETF liquidity, it's essential to consider both the secondary and primary markets. The secondary market liquidity is reflected by the bid-ask spread and trading volume on trading platforms, while the primary market liquidity is facilitated by Authorized Participants (APs) who can create or redeem ETFs. This unique creation and redemption process provides primary market liquidity, allowing APs to adjust the ETF's share supply to meet market demand.

When trading ETFs, it is recommended to use limit orders, which give investors control over the execution price. Additionally, considering the time of day is crucial, as liquidity is typically higher during market "rush hours" at the opening and closing.

Frequently asked questions