Common notions of stock trading liquidity should not be applied to exchange traded funds as ETF investors need to also consider the liquidity of the underlying or primary market.
“ETFs are open-end funds, which regularly ‘create’ and ‘destroy’ shares in response to changing supply and demand dynamics,” according to Morningstar strategist John Gabriel. “As such, they have two distinct sources of liquidity: primary markets, where shares are created and destroyed, and secondary markets, where they are quoted and traded in much the same way as stocks.”
ETFs, like mutual funds, create and redeem fund shares, depending on level of interest in the ETFs. When an ETF attracts an influx in new money, the fund provider will work with authorized participants to create new ETF shares in exchange for a basket of underlying securities. On the other hand, if an ETF experiences large outflows, ETF shares can be redeemed for a basket of underlying securities.
If left unattended, ETFs may generate large premiums to their net asset value if enough investors hop on to a trade, or ETFs may see large discounts to their NAV if enough selling pressure persists. Consequently, in normal conditions, authorized participants have an incentive to arbitrage the difference, creating or redeeming ETF shares to bring an ETF’s price back to its NAV in the secondary market.
The authorized participants are a group of institutional investors or market makers who work closely with the ETF providers to facilitate efficient ETF trades, serving as the go-between for the primary underlying market and secondary market where the ETF shares are traded. ETF providers would provide a list of securities that make up an ETF”s underlying portfolio so that authorized participants can exchange the basket for ETF shares, or vice versa, for an “in-kind” transaction. [How ETFs Are Traded]
“A critical takeaway is that the number of ETF shares outstanding is dynamic and will wax and wane according to supply and demand in the marketplace,” Gabriel said. “This distinguishes ETFs from stocks and closed-end funds, which tend to have a finite number of shares outstanding. The creation and redemption feature of ETFs represents a unique source of liquidity.”
Consequently, along with the daily trading volume and bid-ask spreads that investors would see on their brokerage account, people need to also monitor the liquidity of the underlying securities, which may arguably be more important for ETFs.
“It is the liquidity of the underlying securities that tends to be a more important factor for determining ETFs’ true liquidity, since that is what determines how easily an authorized participant could go to the capital markets to buy or sell those securities in order to create or redeem new shares in an ETF,” Gabriel added.
If the underlying market is illiquid, authorized participants will have a harder time efficiently creating or redeeming ETF shares, which can lead to greater spreads in the secondary market. This is also the major concern that many fixed-income observers are voicing as the popularity of bond ETFs grows and the underlying debt securities remain less liquid ahead of an interest rate hike. [Liquidity Concerns in Corporate Bond ETFs]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.