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.