There's More to ETF Liquidity Than Meets the Eye
Exchange-traded funds' unique structure provides two sources of liquidity.
One of the most challenging concepts for those who are new to exchange-traded funds to grasp is the multifaceted nature of their true liquidity. ETFs are open-end funds, which regularly "create" and "destroy" shares in response to changing supply and demand dynamics. As such, they have two distinct sources of liquidity: primary markets, where shares are created and destroyed, and secondary markets, where they are quoted and traded in much the same way as stocks.
When transacting in traditional mutual funds, investors typically deal directly with the fund company. When investors put new money into the fund, the portfolio manager will put it to work by purchasing securities. Likewise, if there are net redemptions, the manager will sell securities to meet those requests, or tap into the fund's cash holdings. The key point is that the fund itself must access the capital markets in managing the portfolio. Also, all investors, whether they are buying or selling fund shares, will receive an amount equivalent to the end-of-day net asset value, regardless of the time of the day that their order was placed.
John Gabriel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.