ETF Perspectives

Debunking 6 ETF Myths: Actual ETF Liquidity Explained

Published: 14-11-2024

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 the liquidity of the underlying stocks

    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 have a unique creation and redemption mechanism that allows them to issue or redeem shares based on investor demand, unlike individual stocks with a fixed supply. This dual-layer liquidity comprising both primary and secondary markets which enables ETFs to have more dynamic liquidity than individual stocks. While the liquidity of an ETF is influenced by its underlying securities, it is not solely determined by asset size or trading volumes. As ETFs grow and attract diverse investors, secondary market turnover can often meet supply and demand. When imbalances do occur, the primary market facilitates efficient trading of the underlying stock basket, ensuring robust liquidity aligning the market price with its fair value.

The ETF ecosystem: Trading occurs in the secondary market; creation and redemption occurs in the primary market

etf-liquidty-chart-nov-en

Source: J.P. Morgan Asset Management; for illustrative purposes only.

  • 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.

For Professional Clients/ Qualified Investors only – not for Retail use or distribution.

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