» Exchange-traded fund (ETF) Guides » ETF Liquidity

ETF Liquidity

ETFs hold a certain level of liquidity. However, most investors believe that the liquidity of an ETF is based on the number of times the fund is traded. This means that investors focus on the number of shares that have been traded each day.

This represents a commonly held misconception, since the liquidity of an ETF depends on the liquidity of the stocks that are part of the fund.

ETFs are created and redeemed by market makers, who are also referred to as authorized participants (APs). Shares of the companies that make up the foundation index serve as the building basis of an ETF. The market demand of the ETF dictates the creation or redemption of the shares by the market makers.

The creation or redemption of shares by market makers can also be dictated by the need to arbitrage premiums or discount to the underlying NAV. As a result the price of the fund is in accordance with the NAV, which in turn leads to the prevention of unfair markets occurrence. Since marker makers are after profits, this represents a mechanism that is very beneficial to investors.

If a client makes a large order for an ETF, big brokerage houses may take the role of authorized participants. As a result, combined with the brokerage house's ability to obtain the included in the ETF stocks, a large number of ETF shares are created in a liquid index.

Bid-ask spreads of a smaller amount is observed in ETFs that are based on indexes to which derivatives are attached. This is caused by the closer relationship between arbitrageurs, specialists and market makers. The increased competition between these leads to more narrow spreads, which represents a benefit to the shareholders of the ETF. Thus, if an ETF is linked to an index, it will enjoy lower bid-ask spreads.

However, the liquidity of an ETF may disappear when market conditions deteriorate. Nevertheless, you should not avoid investing in US broad-based ETFs, especially if you are confident in the liquidity of the market. You should apply the wait-and-see method regarding ETFs that are linked to indexes that are less liquid, such as private securities and municipal bonds.

It has been proven by various studies that spreads decrease with the increase in popularity of ETFs.

Finally, all you should remember is that the liquidity of an ETF depends on the liquidity of the underlying stocks, not on the number of times the fund has been traded.

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