Exchange traded funds (ETFs) provide access to a diversified portfolio of securities such as stocks or bonds. They are flexible investment vehicles that can be used within a portfolio in many ways to meet different investment needs and objectives. Similar to stocks, ETFs can trade throughout the day on an exchange.
One of the most misunderstood aspects of ETFs is their liquidity. ETF liquidity has two components – the volume of units traded on an exchange and the liquidity of the individual securities in the ETF’s portfolio. ETFs are open-ended, meaning units can be created or redeemed based on investor demand. This process is managed by market makers who provide ETF liquidity on the exchange. The liquidity posted by market makers is affected by how easily the market maker can buy and sell the securities held within the ETF’s portfolio. Thus the liquidity of an ETF is strongly related to the liquidity of the individual securities in the ETF’s portfolio.
The creation and redemption process is known as the primary market. If there is net demand to buy units of a particular ETF, a market maker can create new units by delivering a basket of securities to an ETF sponsor. In return, the ETF sponsor delivers ETF units of equal value to the market maker, which the market maker then sells publicly on the exchange to meet investor demand. The reverse process is followed in case of redemptions, when there is net demand to sell units.
In the secondary market, investors buy and sell the units on the exchange without the ETF sponsor’s involvement. These transactions between individual investors are processed in real time throughout the trading day at market prices.
How do I know an ETF is liquid?
The daily volume traded of an ETF is often incorrectly used as a reference point for liquidity. An ETF’s liquidity is determined by the liquidity of the underlying securities whereas trading volume is influenced by the activity of investors. If an ETF invests in securities that have limited supply or are difficult to trade, this may impact the market makers’ ability to create or redeem units of the ETF which may then affect the portfolio’s liquidity. However, Canadian-listed ETFs predominantly invest in liquid securities that trade on major exchanges around the world.
Low trading volume doesn’t mean low liquidity
You are looking to buy an ETF that holds Canadian large-cap stocks, which you know represent ownership in large, in-demand companies. Your research turns up two ETFs that are almost identical in holdings and bid-ask spread:
At first glance, you may think that you should buy ETF X because it appears to be more liquid – there are more units changing hands with a small bid-ask spread. But, in reality, ETF Y is just as liquid as ETF X because it holds essentially the same securities, which are highly liquid. Facing a choice between two ETFs with similar liquidity, investors should then look to other factors such as product quality, level of service from each provider and management fees to make a decision.