Since ETFs trade like stocks on an exchange, a common misconception is that the liquidity of an ETF can be assessed similarly to how a stock’s liquidity is evaluated. Using common stock liquidity gauges like average daily volume, shares outstanding, order book depth, and spread can provide information of how an ETF has traded historically, but these on-screen or surface liquidity metrics do not paint a full picture of how liquid an ETF is.
Due to their unique structure, we need to think about ETF liquidity differently than we do equities. The liquidity profile of an ETF is ultimately driven by three interrelated factors: 1) the flexible supply of shares due to the creation / redemption mechanism, 2) the liquidity of the ETF’s underlying portfolio, and 3) the arbitrage relationship between the ETF’s market price and its net asset value (NAV). Below we will look at these three factors and how they interplay to create a full picture of liquidity.
#1 – The Creation / Redemption Mechanism
ETFs require special actors in the financial system, called authorized participants (APs for short), to facilitate the exchange of ETF shares for baskets of the underlying securities. APs are typically large financial institutions specifically contracted by ETF sponsors to create and redeem ETF shares. Through the dynamism of the ETF share creation / redemption process, the supply of shares can change as market demand for them warrants. When demand for ETF shares outstrips supply (i.e., more ETF buyers than sellers), APs can deliver a basket of the ETF’s underlying securities to the ETF sponsor and receive new ETF shares in return. The new ETF shares are then disseminated into the market to meet demand. On the other hand, when supply outstrips demand (more ETF sellers than buyers), the process works in reverse. APs will send ETF shares to the ETF sponsor, who delivers the basket of underlying securities to be sold in the market. The redeemed ETF shares are removed from circulation by the sponsor. These transactions are executed in increments known as “creation units” of ETFs shares, which are predetermined, large blocks of ETF shares that can be exchanged for a specific basket of underlying securities. This process is what makes ETFs so appealing to investors of all types: the hassle of buying and selling baskets of different securities is taken care of by the APs. The ETF investor receives exposure to the underlying securities but only needs to worry about buying or selling one thing: the ETF shares.
So how does the creation / redemption process factor into an ETF’s liquidity? This brings us to #2.
#2 – Underlying Security Liquidity
A critical driver of an ETF’s liquidity is how easy and cheaply it is for APs to source and trade the securities in the ETF’s underlying basket. As noted above, APs use the creation / redemption mechanism to handle supply and demand imbalances for an ETF’s shares. Each day, the ETF sponsor will post the underlying basket of securities and share amounts that they will accept in exchange for one creation unit of ETF shares. This basket is typically a pro rata slice of the ETF’s portfolio. If, for example, an AP must facilitate the creation of new ETF shares, they need to source and trade the underlying securities to deliver to the ETF sponsor in return for those shares. The ease with which APs can exchange underlying securities for creation units of ETF shares (and vice versa), is a critical factor in an ETF’s liquidity. In other words, the more liquid the underlying securities in the basket, the larger the trades that can be facilitated by APs through the creation / redemption mechanism before there may be market impact on the ETF or underlying securities. Some small ETFs can handle trades in the 100s of millions of dollars (if not more) before the market would be impacted due to the high liquidity of the underlying holdings. When assessing an ETF for yourself or for a client, be sure to look closely at the underlying holdings of the ETF. Baskets of popular equities, bonds, options, and other ETFs (known as “fund of funds”) typically indicate reasonable liquidity.
That brings us to the last component of understanding ETF liquidity: arbitrage.
#3 – Authorized Participant Arbitrage
The role of arbitrage is the last critical component in understanding ETF liquidity and is the bridge that links together #1 and #2. An arbitrage relationship exists between the ETF’s market price (i.e. the price it is trading in the market) and its net asset value (NAV); the value of the ETF’s underlying securities. Typically, the bid/ask spread of an ETF will float around its NAV, so the market price stays in line with the NAV throughout the trading day. However, sometimes the market price will drift away from the NAV, and this presents an opportunity for an authorized participant to make money. To illustrate, imagine an ETF with a NAV of $50.00 per share. For whatever reason, the ETF’s strategy goes out of favor during the trading day, and there happen to be more sellers than buyers. Sellers hit the on-screen bids, pushing the market price of the ETF down to $49.90 per share, despite the NAV still being at $50.00 per share. There is now an arbitrage opportunity for the APs trading this ETF. Remember that the AP is typically a large financial institution with the ability to buy and sell ETF shares and the different underlying securities themselves. If they can buy the ETF at $49.90 and hedge that trade by selling short the underlying basket at $50.00 they will net a $0.10 profit. The AP’s position would then be long ETF shares and short the basket of securities. The AP could then redeem the ETF shares to the sponsor for the basket of underlying securities, netting out their short position and making a profit. In theory, APs would do this trade until the price of the ETF and the NAV move back in line. Because of the nature of this arbitrage relationship, participants in the ETF trading ecosystem act quickly and aggressively to take advantage of any mismatch between an ETF’s market price and its NAV. This activity not only helps minimize premiums and discounts but also incentivizes APs and ETF trading desks to inject additional liquidity into ETFs when necessary.
Putting It All Together
Using the factors above, you have all the tools you need to evaluate an ETF for both its surface and underlying liquidity. Next time you are researching an ETF, keep the following in mind:
- Use surface liquidity metrics like trading volume, shares outstanding, order book depth, and spread to evaluate market demand for an ETF and if you can get into and out of an ETF at a reasonable spread.
- Pay attention to the liquidity of the underlying securities to understand the extent of the risk of the ETF share price getting dislocated significantly from the NAV. If the underlying securities are liquid, the arbitrage opportunity incentivizes APs to keep the share price close to the NAV.
- Monitor the deviation between the share price and NAV over time. This information is publicly available for all ETFs and will give you an indication of how many APs are potentially taking advantage of the arbitrage mechanism and providing a liquid market for the ETF shares.
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