Exchange traded funds (ETFs) cover almost every conceivable area of asset classes. While they trade like stocks on an exchange, ETFs are not confined to the normal notions of liquidity that one would associate with stocks.

Investors normally focus on trading volume and assets when shifting through investments. Low activity could result in wider spreads, higher costs and a shortage of buyers or sellers.  Understanding liquidity is paramount when it comes to ETF trading.

ETF Liquidity
ETF liquidity is reflected by the overall liquidity of securities in the fund's underlying benchmark. Essentially, the liquidity of an ETF is based more on everything within the underlying index than what the daily volume of the ETF actually is.

One of the greatest misconceptions of ETFs is that ETFs with high trading volume are considered liquid, while funds with low trading volume are categorized as illiquid. Trading volume is a backward looking concept, calculated based on past performance, while liquidity is based on current underlying securities.

An ETF's liquidity can be better summed up by the price impact of entering or exiting a position. For instance, when considering different ETFs that track the same index, buy and sell orders should have the same price impact in percentage terms across all those ETF products although the bid/ask spreads could be wider from one ETF to another.

The true liquidity of ETFs can be best interpreted as the combination of an ETF's average daily trading volume and the average daily trading volume of the underlying securities, which makes sense because the value of ETFs come from the value of the securities that underlie them.
The underlying securities have values as determined in an outright market, and ETFs have values based on those securities.

ETF Arbitrage Structure
ETFs were created with a creation/redemption process. The design allows ETF investors to trade intraday, and if executed properly, investors may exit or enter large positions with minimal price impact in terms of the underlying basket.

Just because an ETF is trading at a low volume does not automatically translate into low liquidity. There could be plenty of liquidity in the underlying securities. A trader needs only to be able to successfully access the liquidity. When moving large-block trades in low-volume ETFs, one needs to be able to find someone to create volume based on the underlying liquidity.

Due to the nature of the creation/redemption mechanism of ETFs, a number of firms watch and wait to take advantage of potential arbitrage opportunities where the underlying basket's value --net asset value or NAV -- may trade at a premium or discount to the ETF's listed price via the bid/ask.

Since ETFs are traded on a stock exchange and priced continually, it means that the ETF's price is constantly shifting. Because that price moves freely, a price discrepancy may occur between the price of the fund and its NAV.

If the price of a fund is lower than its NAV, the ETF is trading at a "discount" -- you're buying the ETF for less than the value of the fund's holdings. If the price of the fund is higher than its NAV, the ETF is trading at a "premium" -- the amount you're paying is a little more than what the underlying holdings are actually worth.

To find out if an ETF is trading at a premium or discount, go to Google Finance and type in the ETF ticker, followed by .IV.  For example, the SPDR S&P 500 ETF ticker is SPY, but the underlying trading value symbol is SPY.IV.

Trading firms may buy or sell the underlying basket, take the other side of the trade through the ETF itself and "arb out" the price difference, which keeps trades close to the underlying values.

ETFs generally reflect their true underlying value, which makes them transparent and a more attractive investment for investors who aren't content with closed-ended funds' inherent discount/premium issues.

Concerns About Liquidity?
Advisors concerned about liquidity in a low-volume ETF are not necessarily trapped; there are options. 

Advisors trying to execute orders of 5,000 shares or more should contact a trading desk to help facilitate trades. The trading desk should also be familiar with the pricing nuances of ETFs.

Advisors should opt to avoid the use of market orders, regardless of the ETF. Market orders have the potential to diminish a portfolio's performance due to lost basis points in trades.  Limit orders provide a better alternative and help maintain control on how and when a trade is placed.  However, there is a risk that a limit order will not go through.

One option is the use of an alternative liquidity provider. The provider facilitates the process of trading ETFs by generating a market for thinly-traded funds, making it possible for people to invest in ETFs without worrying about potential liquidity problems.

These liquidity providers have been around since the advent of ETFs, but now have expanded their services beyond institutional clients to assist investment advisors. Their services can offer better access to price discovery and execution for those in need of it.

To ensure smooth block trades in low-volume funds and optimal executions, advisors should be familiar with their custody ETF trading platform and broker-dealer trading desks, as well as have relations with liquidity providers. Liquidity providers and dedicated ETF trading desks will help advisors lock in target-basis points with more efficient executions, and perhaps, even better portfolio performances through optimized trading techniques.