Make the right ETF selection: tips and tricks

For example, if most investors are optimistic about the asset’s future performance, ETF share prices increase, leading to more demand of ETF shares. Short sellers who hold a contrarian view will borrow shares from brokers and sell them when there is more demand for purchases and then buy them back later, when most investors are selling. Liquidity is one of https://www.xcritical.com/ the most important features attracting a diverse group of investors to exchange traded funds (ETFs). To understand where ETF liquidity comes from, explore the mechanics of ETF trading and the roles played by key members of the liquidity ecosystem.

Understanding ETF trading and liquidity: The Basics

All ETFs are listed on a stock exchange, even if their underlying assets aren’t equities. That means that historically difficult-to-trade assets, such as bonds or commodity futures that are part of an ETF, benefit from the secondary-market liquidity. These professionals seek to keep supply of ETF shares in the secondary market in line with demand, by adding new ETF shares (creations) or removing ETF shares (redemptions). Their primary focus is to facilitate an orderly market etf market making to build confidence that investors can find liquidity when they need it.

Determining the Liquidity of an ETF

Suppose a firm named GreenTech ETF tracks the clean technology sector. One day, a breakthrough invention in solar energy creates waves of excitement in the market. Investors move to buy shares of GreenTech ETF to capitalize on this trend. The sudden surge in demand could drive the share price of the ETF sky-high, deviating from the actual value of the underlying assets or its NAV.

ETFs with Wider Bid-Ask Spreads are Less Liquid

If creations and redemptions are easily facilitated, the actual trading volume in the ETF may not matter as much. Alternatively, even if an ETF has a high trading volume and a lot of interest, but the underlying shares are illiquid, APs may find engaging in creations and redemptions difficult. The “secondary market” liquidity seen on exchanges is important for ETF investors and traders.

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The liquidity of fixed income or derivative-based ETFs is a little more difficult to gauge and implied liquidity is not calculated for fixed income or futures based ETFs. When it comes to fixed income ETFs, it is even more critical to understand the liquidity of the underlying securities. As an example, let’s look at the ultra-short market since this category does not invest in government securities as its primary goal. Many investors would think that these securities are very liquid and easy to buy because they are traded more frequently or they mature faster. Another misconception is that these securities have a very tight trading spread. There are several ways to figure out the liquidity of a fixed income or derivative-based ETF.

Who Are the Major Liquidity Players in the ETF Market?

Primary Market The market where Authorized Participants (APs) create and redeem ETF shares in-kind, typically in blocks of 50,000 shares, which are known as creation units. These desks actively transact in the underlying ETF to dynamically hedge their position(s), as they facilitate transactions on a variety of financial instruments for institutional clients. Additionally, ETFs seeking to track indices linked to other structures, such as swaps and futures, are often used in relative value arbitrage between vehicles.

Be Ready for Any Market with Liquid ETFs

Liquidity The ability to quickly buy or sell an investment in the market without impacting its price. Bid/Ask Spread The difference between the highest price a buyer is willing to pay for an asset and the lowest price the seller will accept to sell. Brokers and dealers execute trades on behalf of clients by routing orders to trading venues or by matching buyers and sellers directly.

All investing is subject to risk, including the possible loss of the money you invest. If your trade is less than 5% of ADV, consider using a limit order or marketable limit order to avoid any unintended executions. In the end, the dynamic between both layers of liquidity requires attention and, at times, flexibility. However, keep in mind there are times when an incorrect security shows up in the calculation, which can skew the number. That’s why it is important to look at more than one metric to see if an ETF is liquid. This document may contain statements that are not purely historical in nature but are “forward-looking statements”, which are based on certain assumptions of future events.

ETF selection criteria: This is what you should consider when selecting an ETF

Retail investors can only buy or sell ETF shares on a secondary market exchange. Investors and traders in any security benefit from greater liquidity—that is, the ability to quickly and efficiently sell an asset for cash. Investors who hold ETFs that are not liquid may have trouble selling them at the price they want or in the time frame necessary. Moreover, if an ETF invests in illiquid shares or uses leverage, the market price of the ETF may fall dramatically below the fund’s NAV. For each ETF there are multiple market participants with bid and offers in the market, each of which wants the opportunity to match buyers and sellers. This competition makes execution very efficient for investors as each participant wants to show their very best price.

Exchanges, such as stock exchanges, allow for fair and orderly trading and efficient circulation of securities prices. Exchanges give firms looking to market publicly listed securities the platform to do this. Before creating ETF shares, market makers may need to source underlying securities in the ETF basket by tapping into their own inventory or buying from the underlying security market. The most reputable liquidity providers have servers positioned in major data centers (e.g. LD4, FR5) near the biggest exchanges that deliver ultra-low latency & fast execution speed.

An AP assembles a basket of the underlying clean tech stocks that GreenTech ETF tracks and exchanges it with the ETF issuer for new shares of GreenTech ETF. These new shares are then introduced in the market, increasing the supply to meet the burgeoning demand. This helps keep the price of GreenTech ETF in check, ensuring its price is closely aligned with the NAV. That ready accessibility of ETF shares on a stock exchange means that ETFs are often trading at lower cost in the secondary market than they would if they were accessible only in the primary market. Trades in the primary market in most cases would be more expensive, and operationally more difficult, than a straightforward brokerage account trade in the secondary market. These transactions may impact the liquidity of underlying security markets.

Feeds should reflect prices from the interbank foreign exchange markets and underlying instruments from a list of stock exchanges. Retail clients and brokers should have the possibility to compare those prices in a convenient way. Access to historical market data and the tick data is an essential part of the solution as well as a complete order book presented via FIX protocol or trading terminal offered by the LP. In a general sense, a liquidity provider connects customers with the institutions that issue an asset.

Brokers rely on liquidity providers to provide smooth trading conditions and asset availability. The choice of the index or sector tracked by an ETF can significantly affect its liquidity. If an ETF tracks a well-known, widely followed index with liquid underlying assets, it’s likely to have better liquidity. Conversely, ETFs tracking obscure or less liquid indexes may face liquidity challenges, as the underlying assets might be harder to trade, affecting the efficiency of the creation and redemption process. Conversely, if some or all the underlying stocks are illiquid—they are hard to buy or sell without significantly affecting the price—the APs might face challenges in assembling or disassembling the baskets quickly. This delay could affect the timeliness and efficiency of the creation and redemption process, affecting the liquidity of the GreenTech ETF.

• All ETFs are listed on a stock exchange, even if their underlying assets aren’t equities.
• The information provided on the Site is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.
• The concept of liquidity in ETFs extends beyond the traditional understanding applied to individual stocks.
• At first glance, the historical volume in the hypothetical example above (15,820), may lead you to think that it is not a very liquid ETF.
• That’s because the market maker tapped into the primary market liquidity of the underlying securities in the ETF’s basket to provide great execution quality for the client in the secondary market.
• There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.

These mechanisms adjust supply to meet demand and help maintain the ETF’s price stability and liquidity, which are crucial for an efficient trading experience and fair asset valuation for investors. And the second layer that market makers will consider is the market impact of the underlying securities, which is often minimal given the diversification. Using Vanguard S&P 500 ETF (VOO) as an example, you would need to trade $1.5 billion of the ETF to move just 1% of Apple’s (AAPL) average daily volume. The liquidity provider’s use of these features—and our guidance to clients on how to utilize these features to their advantage—is designed to keep trading costs as low as possible. Most ETF orders are entered electronically and executed in the secondary market where the bid/ask prices that market participants are willing to buy or sell ETF shares at are posted. Secondary market liquidity is determined primarily by the volume of ETF shares traded.

VTI’s ADV, while plentiful, was not a significant concern in that trade. That’s because the market maker tapped into the primary market liquidity of the underlying securities in the ETF’s basket to provide great execution quality for the client in the secondary market. Simultaneously making offers to buy (bid) and sell (ask) securities at specified prices, market makers provide two-sided liquidity to other market participants.

They charge commissions for their services to execute and settle trades. A primary market that supports the ETF’s liquidity and allows them to trade close to Net Asset Value (NAV) throughout the day. The investor has to decide on the best course of action to protect the investment and determine whether to sell the ETF shares before the “stop trading” date or hold on to the ETF shares until liquidation. As of Nov. 2023, over 3,000 ETFs were listed on U.S. exchanges with combined assets exceeding $7.6 trillion. ETFs range from traditional index ETFs based on U.S. and international equity indexes and subindexes, and others that track benchmark indices in bonds, commodities, and futures.

Net Asset Value (NAV) The price of a share determined by the total value of the securities in the underlying portfolio, less any liabilities. Let’s break Figure 1 down to understand the key ETF trading activities point by point. Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.

In exchange for the basket of securities, the ETF custodian provides shares of the ETF to the AP at the net asset value. ETF liquidity is based on the dynamics in the dealer and secondary markets. Dealers acting as APs can create and redeem ETF shares to meet supply and demand changes in the ETF and keep its market price in line with its NAV. On the secondary market, ETF shares with higher trading volume and tighter spreads are usually more liquid. Secondary market liquidity is the ease with which investors can buy or sell ETF shares on exchanges, much like individual stocks. This liquidity is visible through metrics such as trading volume, market depth, and the bid-ask spread.