By IndexIQ via Iris.xyz

There’s no doubt about it: ETFs can be powerful investment tools. And yet, because ETFs are relative newcomers to the market, many investors are still struggling to understand when, how, and why to use them as part of a strong investment strategy. One of the biggest misunderstandings we’ve seen is how an ETF’s liquidity is actually determined. And because liquidity is often a key factor when selecting any asset, it’s important to be sure you’re really comparing apples to apples. Otherwise, you risk leaving opportunity (and sometimes a very good one!) on the table.

It’s no wonder there’s so much confusion on this topic. Most of us learned our investing ABCs using stocks as the main model. We learned—correctly—that a security’s liquidity is determined by its average daily trading volume, or ADV. That fact tells us that a stock that trades one million shares per day, for example, is many times more liquid than a stock that only trades a thousand shares each day. ETFs, however, function quite differently than other securities. As counterintuitive as it may seem, an ETF that trades a few thousand shares per day may be just as liquid as one that trades one million. In short, ADV does not determine ETF liquidity.

How can that be? It’s all in the ETF’s unique structure.

As you know, every ETF is comprised of an underlying basket of securities. That basket is divided into shares that are traded on an exchange. An investor buying a share of an ETF is effectively purchasing a portion of each one of those stocks in the ETF’s portfolio—in some cases, hundreds of stocks at once, all with a single trade.

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