ETF Liquidity: It's All About the Basket

As any savvy investor knows, a stock’s liquidity is a crucial consideration in the purchase decision. Most investors prefer the relative comfort of knowing there’ll be a ready market for their shares should they choose to sell. They know that buying illiquid assets can add another layer of risk to an investor’s portfolio, one that needs to be carefully considered and one from which many investors shy away.

But while liquidity is a straightforward concept when comparing one stock to another (the higher the trading volume, the higher the liquidity), that guiding principle doesn’t apply in the world of ETFs. That’s why it’s vital for anyone investing in ETFs to understand how liquidity works in these funds. The most important thing to understand is that ETF liquidity is dictated not by the ADV (average trading volume) of the fund itself, but instead by the “underlying basket” of securities within the fund. And while that concept may feel foreign to anyone new to ETFs, it’s pretty simple once you understand the basics.

Here’s what you need to know to be sure you’re not only considering the most appropriate ETFs for your portfolios, but also that you’re not ruling out high-value ETFs that may be a suitable fit for an individual’s investment objectives.

1. Average trading volume (ADV) has a direct relationship to the liquidity of common stock.

In general, higher the trading volume of a stock, the greater the liquidity of the security. Knowing that, if you’re seeking liquidity, it makes sense to rule out stocks with lower ADV when building your portfolio.

2. Average trading volume (ADV) does not determine ETF liquidity.

The liquidity of an ETF is driven by the liquidity of the stocks or other securities that are held in the ETF’s Fund portfolio. Because this “underlying basket” of securities is divided into shares that are then traded on an exchange, an ETF that trades a few thousand shares per day may be just as liquid as one that trades a million shares a day.

3. An ETF’s liquidity is measured by the liquidity of the contents of its underlying basket—not it’s ADV.

This relationship is called “implied liquidity¹,” and it’s measured by determining the number of ETF shares that can be traded without executing a set percentage—usually 25%—of the ADV in any of the securities in the underlying basket

4. ETFs can be traded in sizes that are large multiples of their ADVs without impacting the price.

Unlike common stocks, the number of outstanding shares of an ETF can be increased or decreased on a daily basis in response to investor demand. Because an ETF’s shares outstanding can change daily, ETF traders and investors have access to the liquidity of the underlying securities in the Fund—the ETF is just a wrapper for delivering those underlying securities. As a result, investors can access large share volumes of an ETF that has a relatively low ADV without impacting the price of the ETF itself.

5. The implied liquidity of an ETF—not it’s ADV—dictates its suitability within a portfolio.

Liquidity is a driving factor when choosing the most suitable ETFs within a portfolio. Using implied liquidity, rather than ADV, as the key selection factor, and suddenly the menu of suitable ETFs expands dramatically.

Clearly, determining the implied liquidity of an ETF is far more complex than simply looking at the fund’s ADV. Luckily there are plenty of resources available to help. Most active ETF traders work with liquidity providers who offer the tools to evaluate the liquidity of the underlying basket for any given ETF, and then provide a fair price for a large block of shares to the client. Bloomberg offers an implied liquidity field listing, and most fixed income or derivative-based ETFs sponsors have a capital markets desk that can provide the information you need. The most important thing is to be sure you’re choosing the right ETFs for the right reasons. Liquidity matters, and knowing how it works in ETFs can help you make smarter decisions every time.

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1 Implied liquidity refers to an ETF being as liquid as its underlying basket.
IndexIQ ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC. Sal Bruno is a registered representative of NYLIFE Distributors LLC