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Liquidity is a term used by investors to gauge how easy it is to transact with a security (buy or sell). The higher the liquidity the better, as you can easily purchase or sell a stock, bond or ETF. Liquidity for individual stocks and bonds is typically measured off average daily volumes and bid-ask spreads.

ETF liquidity is a little more complicated by virtue of it being a fund that owns a portfolio of securities. While at first glance many investors would look to the same metrics they typically do with stock liquidity: "what's its volume and spread?" The answer to this question lies with it's underlying holdings.

How ETFs Operate

Exchange Traded Funds are investment vehicles that own a basket of securities, just like a mutual fund. However, because they are exchange traded - meaning you can purchase it directly on a stock exchange, the way they hold these securities and transact are different than a normal mutual fund. ETF providers (like BlackRock, or Vanguard) create a new ETF product and partner with an Authorized Participant (AP) to issue and redeem units of the fund in exchange for the underlying holdings of that ETF.

When large orders come in, or the market price of the ETF drifts meaningfully from the fair value of the underlying holdings, an AP will come in to restore balance. If the ETF is trading above its NAV (Net Asset Value), the AP will purchase the underlying basket of securities and exchange that with the ETF provider for units of the ETF - then sell those units on the exchange to ordinary investors.

If the ETF is trading below its NAV, the AP will buy up ETF units on the exchange, return those to the ETF provider who will exchange those units for the underlying basket of securities.

While this may sound complicated - the main takeaway is the AP helps keep market price in-line with NAV, the fair value of the underlying portfolio.

Analyzing ETF Liquidity

The first instinct for many investors is to look at the daily volume of the ETF they want to buy. With many eschewing from funds that have low volume.

However, the more important consideration when analyzing ETF liquidity is looking at the underlying liquidity of its individual securities. This is important for two main reasons:

1. Market participants like APs or market makers are incentivized to transact in an ETF should price drift from NAV of the fund.
2. With any market sell-off, an investor looking to sell out of an ETF would find it more difficult to sell out of one who's underlying constituents are thinly traded because the AP can't restore balance as easily.

The easiest way you can analyze an ETF's underlying liquidity is to analyze its core holdings. If the fund invests in liquid companies like U.S. tech giants, chances are the liquidity of the ETF is high (even if it doesn't trade much itself).

If it invests in small-cap international companies or fixed income securities, liquidity may play a more important part of your ETF selection process.

Concluding Thoughts

Instead of analyzing the daily volume of an ETF, look to its underlying holdings for an indication of its true liquidity. ETF players like market makers or authorized participants are there to ensure the market price of the fund is in-line with NAV and will fill your orders - permitting the underlying holdings are liquid.

If you need help analyzing ETFs, check us out. We provide an intuitive way to research and build custom ETF portfolios.

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