For individual stocks, liquidity is about trading volume. For ETFs, there’s more to consider.
ETFs have 2 layers of liquidity: liquidity of the underlying securities, i.e., the primary market, and the available liquidity in the secondary market. While the factors that determine liquidity are not the same in the primary and secondary markets, both help ensure the orderly trading of ETFs.
On a high level, liquidity in the primary market is tied to the value of the ETFs' underlying securities, whereas in secondary market it's related to the value of the ETF shares traded.
Primary market liquidity
One of the key features of ETFs is that the supply of shares is flexible. In other words, shares can be “created” or “redeemed” to offset changes in demand. ETF creation and redemption is aided by tapping into the liquidity of an ETF’s underlying portfolio of securities.
In the primary market, a specific type of entity known as an “authorized participant” (AP) can change the supply of ETF shares available. The AP can offload a large basket of shares (i.e., redeem) or acquire a large basket of shares (i.e., create) directly from the ETF issuer. Typically, the AP is doing business in the primary market to meet supply and demand imbalances from the trading that happens in the secondary market. Ultimately the primary market helps provide for additional liquidity in the secondary market.
Secondary market liquidity
Most ETF orders are entered electronically and executed in the secondary market where the bid/ask prices that market participants are willing to buy or sell ETF shares at are posted. Secondary market liquidity is determined primarily by the volume of ETF shares traded.
To assess secondary market liquidity, follow an ETF at different times of day, over various time periods, and note how it’s affected by market environments. Some of the statistics you might want to focus on include average bid-ask spreads, average trading volume, and premiums or discounts (i.e., does the ETF trade close to its net asset value?).
Evaluating ETF liquidity
Most investors simply look at secondary market liquidity. But the key point is that both primary market and secondary market liquidity play a role in providing a full picture of ETF liquidity.
Although non-institutional investors tend to trade in the secondary market, retail and advisor investors may benefit from both primary and secondary market liquidity. Here’s an example: If a high-powered investor is placing a trade for tens of thousands of shares, they’re likely to source liquidity through the primary market as an AP fulfills that liquidity demand.
Knowing more about liquidity in the primary and secondary markets may help you evaluate ETFs more strategically.