Are ETFs Liquid Enough for Your Trading Needs

ETFs can be a great way to diversify your investment portfolio, but their liquidity is a crucial factor to consider. In fact, some ETFs have a liquidity ratio of less than 1%, which means that for every dollar invested, only a fraction of a dollar can be easily sold.

According to the article, the average daily trading volume for some popular ETFs can be as low as $100,000. This can be a concern for traders who need to quickly sell their shares.

ETFs with a large market capitalization, such as the SPDR S&P 500 ETF, tend to have higher liquidity ratios. This is because they have a larger number of shares outstanding and are more widely traded.

However, even for these larger ETFs, liquidity can still be an issue during times of high market volatility.

ETF liquidity concerns arise when underlying holdings are composed of small-cap stocks or less-liquid bonds or real assets.

Liquidity challenges can make it difficult to trade in large sizes, especially for index and active ETFs. This is because thinly traded underlying securities can lead to increased bid/offer spreads that investors pay.

Active ETF issuers can steer clear of these thinly traded securities and use liquidity screens to avoid them. They also have more flexibility to rebalance their portfolios, allowing them to exit less liquid underlying securities quicker.

Larger and more heavily traded ETFs tend to have tighter spreads, making it easier to buy and sell shares.

ETF liquidity is determined by trading volume of all underlying holdings in the portfolio creation basket. Market makers would be willing to facilitate new buy orders up to 37 million shares at the current National Best Bid/Offer (NBBO) asking price of $38.26 or lower, depending on trade size.

This equates to a notional value of over $1.4 billion. The secondary market trade would likely flow into the primary market, as new shares would need to be created to meet this outsized demand.

The least liquid ETF holding typically determines how much of the ETF could be bought or sold on a given day without causing undue friction in the underlying security prices. FactSet Research Systems Inc. (FDS) would be considered the least liquid basket holding, per its ADV.

Executing a large lot sale of an ETF can be just as efficient as a buy order. In fact, a large Natixis Vaughan Select ETF block sale of 243,000 shares was executed at a price 1 cent below the iNAV and 3 cents above the NBBO bid, resulting in cost savings of $7,290.

ETF shares can be redeemed directly by a liquidity provider, allowing for more favorable execution prices on large sales. This was the case for the VNSE sale, where the order was executed at a price that beat the on-screen levels.

Liquidity providers ideally avoid selling shares for less than the underlying components' actual worth, which is why the best possible execution price on large sales is often the intraday net asset value (iNAV). This was the case for the VNSE sale, where the execution price was 1 cent below the iNAV.

Using limit orders instead of market orders can help optimize trade execution, especially for large lot trades. For example, a large block purchase of 197,000 shares of LSGR was executed using a limit order, resulting in cost savings of $1,970.

In both the VNSE and LSGR examples, the execution prices were better than the on-screen levels, demonstrating the efficiency of large lot sales in the ETF market.

Active ETFs face unique challenges, particularly when it comes to liquidity.

Liquidity challenges arise when underlying holdings are composed of small-cap stocks or less-liquid bonds or real assets.

Active ETF issuers have the option to steer clear of thinly traded underlying securities and liquidity screens are built into many active ETFs.

Besides, active ETFs have more flexibility to rebalance, allowing issuers to exit less liquid underlying securities quicker.

Larger and more heavily traded ETFs tend to have tighter spreads.

Active ETF spreads can evolve over time as they become more popular, similar to how passive ETF spreads are affected by trading volume.

ETFs are traded on major stock exchanges, just like individual stocks. This allows investors to easily buy and sell shares of the ETF throughout the day.

A single ETF can hold hundreds or even thousands of individual securities, making it a convenient way to diversify a portfolio. This diversification can help reduce risk and increase potential returns.

ETFs are created and managed by a fund company, which is responsible for tracking the underlying index or asset class. The fund company sets the rules for trading the ETF, including the trading hours and minimum trading requirements.

The price of an ETF is based on the net asset value (NAV) of the underlying securities, which is calculated at the end of each trading day. This means that the price of the ETF may not reflect the true value of the underlying securities in real-time.

ETFs can be traded in fractions of a share, allowing investors to buy or sell small amounts of the ETF. This can be especially useful for investors who want to dollar-cost average their investments or trade small amounts of money.

The primary market plays a crucial role in maintaining liquidity in the ETF market.

Authorized participants (APs) can create or redeem large baskets of ETF shares to meet supply and demand imbalances in the secondary market.

These APs tap into the liquidity of the underlying portfolio of securities, helping to offset changes in demand.

The primary market helps to provide additional liquidity in the secondary market.

APs typically do business in the primary market to meet the needs of the trading that happens in the secondary market.

The flexibility of the supply of ETF shares is a key feature of the market, allowing for efficient creation and redemption of shares.

ETF trade execution is a crucial aspect of investing in exchange-traded funds (ETFs). Large trades can be executed at a lower price than the on-screen quote due to economies of scale, as liquidity providers' fixed costs become a smaller percentage of the overall transaction.

Using limit orders instead of market orders can help optimize trade execution for on-screen trading. This is because limit orders allow you to specify a price or better, increasing the chances of getting a better execution price.

A large buy of 243,000 shares of the Natixis Vaughan Select ETF was executed at 1 cent below the iNAV and 3 cents above the NBBO bid, resulting in cost savings of $7,290. This is a significant advantage of executing large block orders.

For large lot trades, it's recommended to consult with an ETF issuer's capital markets team or contact their dedicated broker/dealer ETF block trading desk to facilitate the order. This can help you get the best possible execution price.

A large block purchase of 197,000 shares of LSGR was executed at a price 3 cents above the iNAV and 1 cent below the NBBO ask, resulting in cost savings of $1,970. This shows that executing large block orders can lead to significant cost savings.

Limit orders can be used to specify a price or better, increasing the chances of getting a better execution price. This can be especially beneficial for large trades, where even a small difference in price can result in significant cost savings.

ETF demand and supply is a unique beast, and understanding it is crucial for investors.

ETF shares can be continuously created from the underlying portfolio by market makers, making the secondary market activity more about demand than supply.

Unlike single stocks, investors shouldn't view the Average Daily Volume (ADV) as a barometer for how much liquidity an ETF actually has.

In fact, the liquidity profile of an ETF is driven by the liquidity of the underlying securities it holds.

Active ETF issuers maintain high liquidity in their ETFs by providing the market with daily portfolio disclosure and ensuring the securities they invest in are sufficiently liquid.

Where the underlying securities are highly liquid, the ETF can be relied upon to be liquid, regardless of its investment objective.

However, liquidity challenges arise when underlying holdings are composed of small-cap stocks or less-liquid bonds or real assets.

Active ETF issuers have the option to steer clear of thinly traded underlying securities and can rebalance their portfolios to exit less liquid securities quicker.

ETF issuers engage with banks, brokers, and trading firms known as Authorised Participants (AP) and market makers to provide liquidity for an ETF in the primary and secondary market.

These liquidity providers buy ETF units from issuers and put them on the shelves of the exchange, where investors can buy and sell them.