Can ETFs help enhance liquidity?

Even as exchange traded funds (ETFs) have become increasingly popular among many types of investors, some misperceptions have arisen, including that they are less liquid, or harder to sell than other investments. In fact, the opposite has been true. ETFs are not only generally easy to trade, but they also can play an important role in rebalancing supply and demand during market volatility.

Here’s a look at where ETF liquidity comes from and why it matters for investors.

It’s been said that liquidity is like oxygen: you only notice it when it’s gone. And indeed, under normal conditions, liquidity is taken for granted, with enough buyers and sellers in the market to avoid dramatic changes in an asset’s price as it trades.

That balance can be upset during market crises, when there are often many more sellers than buyers. Liquidity risk is the possibility that a lack of liquidity will make it difficult and costly to enter and, more importantly, to exit trading positions.

ETFs are funds that trade on an exchange, like individual securities. And just like mutual funds and securities, ETF investments will be more or less liquid depending on market conditions; the more liquid they are, the easier and more cost-effectively they tend to trade.

ETF liquidity is derived from two main sources that are constantly interacting, based on market activity.

Because ETF exchange trades match buyers/sellers with no direct trading of the ETF’s underlying holdings, ETF liquidity on exchanges is incremental to underlying market liquidity.

Where does ETF liquidity come from? It’s derived from two main sources that are constantly interacting, based on market activity:

Source 1: The underlying ETF basket

As with mutual funds, ETFs “wrap” a collection of securities, known as the basket. That ETF wrapper is then divided into shares, which are traded freely over an exchange just as a stock is traded. Buying and selling a collective exposure is much easier and cheaper than trying to trade each of the individual securities separately.

The starting point for any discussion on ETF liquidity begins with the basket, and the process for creating and redeeming shares. New shares are created by authorized participants (APs), the specialized firms that buy and sell an ETF’s published basket (a representative portion of its investment portfolio) in exchange for shares; those shares are provided by an ETF sponsor like iShares.

Since the basket can be exchanged for shares at any point (and vice versa), an ETF will be at least as liquid as its underlying basket of securities. Thus, an ETF with an underlying basket of large-cap U.S. stocks will generally be more liquid, with a tighter bid/ask spread, than one that tracks a basket of international small-cap stocks.

Source 2: The stock exchange

ETFs have access to an additional layer of liquidity on the exchange (the New York Stock Exchange, for example). This is where you’ll find almost all individual investors and financial advisors trading ETFs.

ETF liquidity on an exchange is driven largely by supply and demand, as buyers and sellers meet throughout the trading day, just as they would with an individual stock. The ability to match buyers and sellers in this market, without the need to create or redeem shares from the basket, benefits investors by lowering overall transaction costs and fostering greater liquidity.

ETF liquidity on an exchange is driven largely by supply and demand, as buyers and sellers meet throughout the trading day, just as they would with an individual stock.

Most ETF shares trade hands many more times on the exchange than through the creation/redemption process. This is very different from mutual funds, whose only source of liquidity is the fund provider.

Managing liquidity risk in volatile markets

In turbulent markets, there is often an imbalance in the number of buyers and sellers. What happens to ETFs on extreme days, when there is a strong influx of sellers all at once?

In such a case, the APs may step in as a buyer of ETF shares from investors, priced at the value of the securities in the basket. Those shares are handed back to the ETF sponsor in exchange for physical shares of the underlying securities, which the APs can then resell on the market.

Ultimately, reducing the number of shares available on the exchange can improve the liquidity of the market as a whole, by helping to restore the balance of supply and demand. (See “Do ETFs add market volatility?”)

ETF vs. mutual fund liquidity

ETFs and mutual funds have a number of similarities. Both are structured to provide diversified exposure to an asset class or sector, and sliced into shares that reflect a portion of the underlying holdings.

However, during many market environments, ETFs can actually access an additional layer of liquidity on the stock exchange where buyers and sellers can offset each other's transactions without necessarily having to trade in the underlying market.

For more information on the differences between ETFs and mutual funds, please click here.

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