Understanding Underlying Liquidity in ETFs | ETF Trends

Markets seem to have fallen in love with the ETF wrapper. This year, ETF launches are on track to set yet another record in 2023, having last done so in 2021. That said, even with ETFs clearly on the rise as a wrapper, education still matters. Many investors remain more familiar with mutual funds and, while interested in ETFs, want to learn more about what sets them apart. One of the biggest factors, the underlying liquidity question, merits a conversation.

The ETF Liquidity Conversation

Let’s start by talking about mutual funds and how their liquidity backdrop works. For example, to exit a fund, a shareholder invested in a Fidelity mutual fund will sell their mutual fund shares at NAV to Fidelity directly. Then, that fund’s manager either uses cash or sells securities directly from the fund to meet the redemption. From there, the shareholder receives cash based on the NAV of the shares on the day they sold.

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ETFs operate a bit differently. Take a strategy like the Fidelity High Dividend ETF (FDVV), which has $1.7B in AUM as of November 8. There’s the “visible liquidity” from the secondary market as of August 31, with the strategy having a 20-day average volume of $5.7 million. That number comes from the volume of ETF shares traded, per Fidelity analysis.

Primary vs. Secondary Market Liquidity

However, that’s not the whole story for liquidity. An ETF also has hidden liquidity or primary market liquidity. In this case, the implied or basket liquidity for FDVV’s 20-day average volume was $579 million as of August 31 per Fidelity. That liquidity stems from market maker liquidity indications as well as inventory level and creation/redemption liquidity tied to the underlying basket.

Per Fidelity’s ETF liquidity guide, those primary vs. secondary market definitions that undergird those liquidity numbers involve slightly different mechanisms. The primary market involves an in-kind redemption setup.

When a market maker approaches an Authorized Participant (AP), an organization that is often a bank and has the right to create and redeem shares of an ETF, the AP then takes the shares and sells securities to generate cash.

An ETF’s liquidity stems from the overall creation and redemption process in which a sponsor purchases a basket of stocks to represent the holdings of an ETF. The sponsor then issues ETF shares to represent the value of these holdings. In turn, shares can be returned to the sponsor in return for the basket of shares, ensuring the shares no longer trade on the secondary market.

That also creates an “arbitrage” process in which traders may redeem shares if their own prices start to diverge significantly from the NAV of the fund’s portfolio. That helps boost liquidity, as well.

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The AP then delivers the shares to the ETF manager, who sends low-basis securities “in kind” back to the AP in exchange for the ETF shares. Overloading those low-basis securities help ETFs be so tax efficient. Finally, the AP returns the cash generated by selling securities to the market maker.

The Benefits of Underlying Liquidity

The secondary market also involves an intermediary between the shareholder and the Exchange where shares are sold. A broker-dealer operates between the two. The broker-dealer requests the trade on the Exchange and then returns the cash to the shareholder.

Together, these processes support overall liquidity for the ETF wrapper. In short, ETFs are generally described as ‘at least as liquid’ as their underlying holdings. This results from investors having access to the underlying basket (if there is a creation/redemption) and the liquidity the ETF provides. Furthermore, they offer more liquidity than mutual funds have. The most liquid ETFs allow swift transactions at prices closer to the actual value of underlying assets.

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