ETFZone.com did a good job of putting a common misconception on exchange-traded fund liquidity to rest.
They explain that "the best measure of ETF
liquidity is the liquidity of the underlying stocks in the index. Understanding this fact requires a brief look into how ETFs function on a basic level.
Since
ETFs trade like stocks, market makers (also called authorized
participants or APs) are the folks that order the creation and
redemption of ETF shares. Market makers build an ETF share from the
shares of the companies in the underlying index. They create or redeem
shares depending on the market demand for the ETF shares.
It
should also be noted that market makers and specialists can create and
redeem shares to arbitrage premiums or discounts to the underlying net
asset value (NAV). This activity is beneficial to ETF investors because
it keeps the price of the fund in line with the NAV and prevents
specialists from making unfair markets. Think of it as a mechanism that
ensures retail investors like us will get a fair price as the APs step
all over each other trying to make a buck. Pretty neat, huh?"
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.