De-mystifying ETF Liquidity—What does volume really tell you?
“I’ll wait until there is more volume”
“I’m not concerned about getting into the shares but what happens when I need to get out?”
Ever had these thoughts before as you scan through the list of exchange traded funds available on the market today and see something you like for your clients portfolio but are uncomfortable with the fact that its only trading 5,000 shares that day?
It’s a common misconception that liquidity is directly related to the number of shares the ETF trades each day. Let’s take a step back and think about what it means to be an ETF and where the liquidity is coming from.
An ETF is a basket of securities set aside by an index provider to track a specific sector or area of the market in which someone might want to invest. When there is demand for additional shares of the basket of securities (or technically stated, the ETF) an additional unit of typically 50,000 shares is created by an authorized participant (AP) almost instantaneously. Multiple units can be created at a time if necessary.
Those units are then turned over to the market maker who in turn hedges their position to remain market neutral and sells the shares to investors on the open market. As their inventory is depleted they go back to the authorized participant and create additional units. This can be done intraday or after market, whenever demand necessitates.
Here comes the interesting part. What happens if you want to SELL 50,000 shares but the volume stated that day is only 5,000? When this happens you simply put in an order to sell and the market maker is given three options:
- Try to find other buyers
- Keep the position long on their books and hedge their position until more buyers arise
- Redeem the shares via the AP and exchange them for cash.
The AP is contractually obligated to take back the shares as close to the IIV (intraday indicative value) as possible, which is the value of the basket that is posted every 15 seconds. The AP in this case would then either sell the basket as a whole to one of their investors or break it apart into pieces and sell the securities separately on the open market. Either way, you as an investor have full liquidity in your investments regardless of the daily trading volume because the liquidity is in the names of the securities you own, not the ETF basket itself. Next time you are looking at ETF strategies think about liquidity in terms of the liquidity of the underlying stocks in the index—not in the basket that holds the securities.
Information represented in this piece does not constitute legal, tax or investment advice. Investors should consult their legal, tax and financial advisors before making any financial decisions.
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