What is ETF liquidity and why it matters?

Providers with a high trading volume often offer better liquidity, an excellent advantage for investors. This translates into tighter bid-ask spreads and reduced transaction costs, making your ETF trading journey more cost-effective. In our last blog, we discussed liquidity and defined it as a measure of market participants’ ability to trade what they want, when they want, at a mutually agreed upon price for a specific quantity. We explained why liquidity is important to risk management and capital development. We also addressed the factors that contribute to a liquid market, including a high number of participants, a high traded volume, and a relatively balanced and deep order book. Furthermore, novices should be aware that ETF shares are traded on both the main and secondary markets, which may be perplexing for those who are unfamiliar with the market structure.

The more actively traded a particular security is, the more liquid it is; therefore, ETFs that invest in actively traded securities will be more liquid than those that don’t. However, even funds with limited trading volume can trade at tight spreads if the underlying securities of the fund are liquid. An ETF that invests in S&P 500 stocks, for example, will probably be more liquid and trade at tighter spreads than one that invests in Brazilian small-caps or alternative energy companies. Check the key statistics tab on any ETF to see a full breakdown of liquidity statistics. That’s enhanced by the primary market liquidity of the ETF’s underlying securities, which is sometimes even greater than an ETF’s secondary market liquidity. Price discovery helps investors identify the proper market price of securities or other instruments based on factors like supply and demand.

• The views and strategies described may not be suitable for all investors.
• At first glance, you may think that you should buy ETF X because it appears to be more liquid – there are more units changing hands with a small bid-ask spread.
• The primary market is where the process of creation and redemption takes place.

ETFs are subject to market fluctuation and the risks of their underlying investments. Sometimes, fund managers will buy only some—not all—of the stocks or bonds in an index. On the surface, ETFs that have low volume may appear to be less liquidity, but that may not always be the case. Notice that even at this high an AUM, sudden spikes in price-nav difference are possible. If the appointed AP is active enough (interested enough?) I think such spikes should not occur, at least should not last this long. Of course, this difference is small compared to the absolute value of the NAV, and in this post, I have only considered absolute differences.

What is an ETF liquidity provider?

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. ETFs are open-ended, meaning units can be created or redeemed based on investor demand. This process is managed by market makers who buy and sell ETFs throughout the day. How easily the market maker can deliver or sell securities depends on the liquidity of individual securities in the ETF portfolio. It is a crucial player in the ETF market, also known as a market maker.

Another critical function of an ETF liquidity provider is to maintain the market’s efficiency. As a result of LPs, shares are suggested by their actual worth, and during so-called stress times, liquidity providers restore prices to their true value line. Exchange Traded Fund (ETF)
An ETF is an open-ended fund that provides exposure to underlying investment, usually an index. Like an individual stock, an ETF trades on an exchange throughout the day. Unlike mutual funds, ETFs can be sold short, purchased on margin and often have options chains attached to them. More significantly, institutional investors could use ETFs to quickly enter and exit positions, making them a valuable tool in situations where cash needed to be raised quickly.

Notice that although the difference is noticeably large, at least it swings both ways (+ and -). Over 10 years, although the big difference spikes have reduced, the range is more or less the same. In summary, there are multiple dimensions of measuring ETF liquidity.

If a given ETF is not liquid enough, it makes buying and selling it harder, as there are fewer actors on the market willing to trade the ETF in question. This can widen bid-ask spreads, making it a bit more difficult to trade on movement gains. When executing a large trade that runs into thousands of ETF shares, investors https://www.xcritical.in/blog/etf-liquidity-provider-why-it-matters-and-how-to-choose-one/ can circumvent an illiquid secondary market by directly engaging with the AP to create new shares in the primary market. The primary market is concerned with the high demand and supply of institutional or non-institutional investors who buy and sell ETF shares in bulk in tandem with the Authorized Participant.

Sometimes, low-volume ETFs can have strong market depth due to presence of active market makers making bids and offers. Also, if the ETF has active market makers, it is possible that your order (limit) gets executed even though it may not show up in the order book. Exchange
The marketplace where securities, commodities, derivatives and other financial tools such as ETFs are traded. Exchanges, such as stock exchanges, allow for fair and orderly trading and efficient circulation of securities prices.

Key criteria of a reliable ETF liquidity providerTake the following important factors into account:

The on-exchange trading of ETFs plays an important role in price discovery across markets, sectors and individual stocks. Alternative investments involve greater risks than traditional https://www.xcritical.in/ investments and should not be deemed a complete investment program. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing.

In exchange for the basket of securities, the ETF custodian provides shares of the ETF to the AP at the net asset value. 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 the underlying securities whereas trading volume is influenced by the activity of investors.

PTFs do so by effectively processing market information from many public sources and efficiently deploying their capital. When pulling up a quote on a proprietary system or through a financial website, the secondary market is what you see. A common misconception holds that to get best execution an ETF must possess significant average daily trading volume. That’s because executed share volume pertains only to the secondary market exchanges on which the ETFs trade.1 It is only an indication of what has traded, not what could trade.

Usually you won’t have any problems with a big name, like the Vanguard Total Stock Market ETF or Invesco’s QQQ. However, a smaller niche ETF like a South-American Green Energy Small Cap ETF can have very low, if any liquidity. Bid-ask spread is the difference between the best buy and the best sell orders. The products and services described on this web site are intended to be made available only to persons in the United States or as otherwise qualified and permissible under local law. If a fund has the right strategy and is well run, you then decide if you can buy it. After all, trading costs can really eat into your returns if you’re not careful.

Exchanges give firms looking to market publicly listed securities the platform to do this. Liquidity providers relate to the secondary market, serving as mediators between brokerage companies and investors. As with any financial security, not all ETFs have the same level of liquidity. An ETF’s liquidity is affected by the securities that it holds, the trading volume of the securities that it holds, the trading volume of the ETF itself, and, finally, the investment environment. Being aware of how these factors affect an ETF’s liquidity, and therefore how its profitability will improve results, becomes especially important in environments where every basis point counts.