Advisors, institutions and retail investors have had certain notions on the ability to execute an optimal trade based on the perceived liquidity of a specific exchange traded funds (ETFs). However, what has been used to determine a stock’s liquidity can’t be applied to ETFs.

Attributes such as trading volume and assets used to be major considerations for investors because it tended to be that low activity in a fund led to wide spreads, bigger costs and, in a worst-case scenario, no one there to buy the fund you’re holding when you’re in the market to sell it.

If you’re an advisor concerned about liquidity in low-volume ETFs, you’re not helpless. Among your options is using the services of alternate liquidity providers.

The providers facilitate the process of trading ETFs by providing a market for even the most thinly-traded fund, and they’re opening up new worlds for advisors and investors, making it possible for them to invest in ETFs that they once feared would be illiquid. The services of liquidity providers give advisors better access to price discovery and execution.

Paul Weisbruch, Vice President of ETF/Options Sales and Trading at Street One Financial, provides some answers on liquidity commonly seen with ETFs.

How is the liquidity of an ETF determined?

ETF liquidity is reflected by the overall liquidity of securities in the underlying benchmark that the ETF tracks. Basically, “ETF liquidity has everything to do with ‘what is inside the index, or basket’ that the ETF is based upon and has very little to do with the daily volume in the product.”

It is a common misconception that ETFs with high trading volumes are liquid while those with low trading volumes are deemed illiquid. Street One defines liquidity in terms of “price impact of entering or exiting a position.”

For instance, in examining SPDR S&P 500 (NYSEArca: SPY), iShares S&P 500 Index (NYSEArca: IVV), Rydex S&P Equal Weight (NYSEArca: RSP) and RevenueShares Large Cap (RWL), the four equity products are all based on the S&P 500, with SPY and IVV weighted by market capitalization, RSP using an equal-weighted methodology and RWL being revenue-weighted. Overlooking the fact that the ETFs trade at varying levels of volume, these four ETFs hold a basket that are identical name for name.

If traded properly, buy and sell orders should have around the same price impact in percentage terms in all of the above products although bid/ask spreads will be wider from one ETF to another. But that said, no one said you have to trade with the visible bid/ask spreads.

How does the structure of an ETF affect liquidity?

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