As exchange-traded funds (ETFs) and stocks both trade on an exchange, investors may assume that, like stocks, ETF liquidity is determined by the volume of trading or outstanding units. This leads to the common misconception that ETFs with lower average daily trading volumes are less liquid or, in other words, more difficult to trade and have wider spreads.
What does ETF liquidity have to do with its underlying securities?
While trading activity on an exchange is the most visible source of liquidity, what truly governs ETF liquidity is the underlying securities of the portfolio, not the number of units or trading. For example, 1,000,000 units of an ETF would maintain the same liquidity as just one unit of the same ETF that tracks the same underlying securities.
Said differently, if an ETF holds securities that are difficult to trade, don’t trade at a significant daily volume or have a low supply, then the ETF’s liquidity could be an issue.
Creation and redemption makes ETF liquidity distinct
In contrast to the finite supply of individual stock shares available, ETFs can issue or withdraw shares from the primary market as necessary through a process known as creation and redemption. The creation and redemption process is a unique differentiator compared to individual stocks, and helps explain why ETF assets or trading volume do not necessarily determine ETF liquidity.
ETFs have designated brokers and market makers (dealers) who will hold inventory of the ETF units. Once there is enough demand in the ETF, these dealers would approach an ETF issuer to create a new unit (creation unit, typically 50,000 shares) of the ETF. This can be done by submitting the underlying securities of the ETF or cash, or a combination of the two. After the purchase is settled, the dealer can move their inventory of ETF units to the secondary market (a stock exchange).
The redemption process works in reverse – physical securities, cash or a combination of both (held by the ETF issuer) are returned to the dealer to facilitate the redemption, or cancellation, of these units.
Other important aspects to keep in mind
Price, or NAV, of an ETF is determined by the value of the underlying basket of securities, not the supply/demand of the ETF shares.
The supply of ETF shares is open-ended, which is different than stocks because there are a limited number of shares that are issued.
The main source of liquidity for an ETF is based on the trading activity of the securities in the underlying basket.
The main measure of liquidity for an ETF is the average daily trading volume of the securities in the underlying basket of the ETF.
The opinions expressed are those of Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Manulife Investment Management disclaims any responsibility to update such information. Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management Limited, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.
Unless otherwise specified, all data is sourced from Manulife Investment Management. Manulife, Stylized M Design, and Manulife Investment Management & Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and its affiliates under license.