Exchange-traded funds (ETFs) offer several attractive features, including flexible intraday trading, efficient market access and potentially lower costs. While these benefits are clear to many investors, one of the most important ETF features, their liquidity, is less well understood. However, the ability to buy and sell ETFs quickly and easily, and at a reasonable price, is one of the biggest advantages of the ETF wrapper, for both active as well as index-tracking strategies.

Dispelling the myths

To understand the true liquidity of an ETF, it’s important to address the many misconceptions that surround ETF liquidity. Some of the most common ETF myths include:

• Myth #1: ETF liquidity is limited by underlying stocks' liquidity
  Because ETFs and individual stocks both trade on a stock exchange, many investors believe that the factors that determine the liquidity of individual stocks must also determine the liquidity of ETFs.
  
  Reality: ETFs operate in a different ecosystem to other instruments that trade on stock exchanges, such as individual stocks or closed-end funds. Whereas these securities have a fixed supply of shares in circulation, ETFs are open-ended investment vehicles with the ability to issue or withdraw shares in the secondary market according to investor supply and demand. This unique creation and redemption mechanism, the primary market, which is enabled by experienced market makers and capital markets professionals, means that ETF liquidity can be much deeper and much more dynamic than stock liquidity. It also explains why an ETF’s liquidity is predominantly determined by the liquidity of its underlying individual securities, rather than by the size of its assets or by trading volumes.

• Myth #2: ETF trading volumes or fund size indicate ETF liquidity risk
  
  Many investors believe that ETFs with low daily trading volumes or that are small in size (by assets under management) will be difficult or expensive to trade.
  
  Reality: Thanks to the ETF redemption mechanism as well as creation, small ETFs or low ETF trading volumes are usually able to absorb large buy or sell orders while continuing to trade at prices that are typically close to the net asset value of their underlying securities. Remember, even the largest ETFs by assets had few assets on day one.
  
  
• Myth #3: ETF secondary market liquidity is the only indicator of true ETF liquidity
  
  A common misconception is that ETF secondary market liquidity provides enough information to assess true ETF liquidity.
  
  Reality: Market makers—who maintain continuous two-way ETF orders and are a key input to exchange order books—typically displaying only smaller fraction of the volume they are willing to trade. Investors may therefore find that secondary market liquidity is much higher than on-screen indicators suggest. An Authorised Participant can tap into primary market liquidity to fulfil large ETF trades by creating or redeeming ETF shares directly with the fund company.
  
  
• Myth #4: Active ETFs are accessed in the same way as mutual funds.
  
  Some investors believe that active ETFs trade just like mutual funds because they are both actively managed.
  
  Reality: While both are actively managed, active ETFs can be traded intraday, which is no different to trading index-tracking ETFs. Mutual funds, on the other hand, cannot be traded intraday and tend to offer a single subscription/redemption point. For more information, please refer to our ETF trading strategies article.
  
  
• Myth #5: Active ETFs incur higher costs than passive index-tracking ETFs
  
  The perception of higher costs of an Active ETF persists due to the emphasis on management fees and tracking error.
  
  Reality: Active ETFs may have higher tracking errors as they aim to outperform, not mirror, an index. This can lead to performance deviations perceived as extra costs. While management fees might be higher, trading costs can be similar to passive ETFs. Overall costs depend on factors like the underlying exposure, investor strategy, and market conditions.
  
  
• Myth #6: Active ETFs lack transparency compared to index-tracking ETFs
  
  Some investors believe that active ETFs do not disclose their holdings as frequently as index-tracking ETFs.
  
  Reality: UCITS active ETFs provide daily transparency of their holdings, just like UCITS index-tracking ETFs.

Conclusion

An ETF’s liquidity can often be far greater than most investors assume. However, it’s important to work with your ETF provider, especially when placing large trades. Most providers have ETF Capital Markets desks whose role is to work with portfolio managers, authorised participants, market makers and stock exchanges to help assess true ETF liquidity and assist investors with efficient trade execution.