How to Assess an ETF's 3 Liquidity Sources That Affect Trading Strategy

The short-lived but extraordinary market volatility of last August saw an unprecedented number of flash crashes or halts to trading due to technical glitches, that caused order pileups.

Dozens of exchange traded funds (ETFs) traded well below fair market value as orders went unfilled and, consequently, fair value pricing simply could not be updated due to lack of current information.

There seems to be a certain amount of continuing fear among ETF investors and their advisors that an ETF’s market price may not adequately reflect the total liquidity of the underlying portfolio. We believe such fear is largely unfounded, especially for long-term investors. Nevertheless, understanding how ETF liquidity is determined and how it can affect trading practice is important for investors looking to maximize returns. Assessing the liquidity of a particular ETF requires a good understanding of how ETF trading works and how to achieve “best execution” when trading ETFs.

First, it’s critical to understand that ETFs trade quite differently than stocks and other investments. The reason is that the intrinsic value of an ETF reflects the value of its underlying securities. Further, ETFs actually have three sources of liquidity, and each can affect trading strategy for a specific ETF, depending on market conditions.

Level One

Level One is the secondary market. ETFs trade continuously throughout the day just like single stocks, but their price only moves as much as that of the securities in its portfolio or “basket,” as published each day by the ETF sponsor. Unlike stocks, however, the number of ETF shares outstanding may rise or decline, because of a unique creation and redemption process. This allows an ETF to trade significantly more shares than the exchange average daily volume statistics reveal. Therefore, trading volume alone does not equal liquidity.

Trading Tip: If you determine that there are enough shares of a specific ETF available for purchase or sale, you may enter a limit order to ensure a specific price.

Level Two

Level Two is the range of ETF Market Depth, which relies on market makers for indications of ETF liquidity. ETF quotes from market makers often have higher ask and lower bid prices than those shown on National Best Bid Offer.

Level Three

Level Three is the primary market for ETFs, which emerges through the creation and redemption process. In a creation transaction, an authorized participant (AP) – a market maker or a large trading firm that handles all aspects of client activity itself – assembles a portfolio that comprises the ETF unit.

Typically, the portfolio involves 50,000 or 100,000 shares as determined by the ETF sponsor. The AP then turns the basket, which is a defined group of securities, over to an ETF distributor and a custodian who in turn provides shares of the ETF to the AP at the net asset value (NAV). The NAV of an ETF is reached by deducting the fund's liabilities from the market value of all of its shares and then dividing by the number of issued shares. In a redemption transaction, the process works in reverse. This process facilitates a pricing discipline for any ETF, helping to ensure that an ETF’s market price doesn’t shift far from the value of the underlying securities.

Being mindful of ETF liquidity and trading practices may help you better maximize opportunities and optimize trades at the best possible price in order to gain potentially higher total returns.