There's More to ETF Liquidity Than Meets the Eye

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.

In the case of buying and selling shares of an ETF, things work a little differently. Instead of going directly to the fund company, buyers and sellers go to the exchange and transact with one another in the secondary market. Anyone with an online brokerage account can type in an ETF ticker and transact any time the market is open, much like they would if they were buying and selling shares of

Only authorized participants deal directly with the ETF companies. Authorized participants are institutional investors or market makers who are under contract with the ETF providers to facilitate the tight tracking and efficient trading of their funds. They serve as the bridge between the primary and secondary markets. Primary market transactions occur between the authorized participants and the fund providers in the form of ETF share creations and redemptions. Each day, ETF sponsors provide the designated brokers with a list of securities (including the number of shares) that make up an ETF's underlying portfolio or some approximation or sampling thereof. The basket of securities (the creation or redemption basket) and the ETF shares are of equal value and can be exchanged on an in-kind basis.

When there is buying pressure or increasing demand for a particular ETF in the secondary market, the market price of the ETF may start to develop a premium, which means that it exceeds the fund's NAV. Since the creation basket can be exchanged directly for ETF shares, there is a profitable arbitrage opportunity for the authorized participants. They can create new shares and subsequently sell them on the secondary market, capturing a portion of this premium for their efforts. This act will serve to collapse the premium, bringing the price of the fund's shares back into alignment with its NAV.

This same process works, in reverse, when there is selling pressure. In this case, an ETF's market price may start to trade at a discount to its NAV (and its redemption basket) as sellers outnumber buyers. In this case, the authorized participant will purchase the discounted ETF shares on the secondary market and deliver them to the fund provider in exchange for the underlying securities (the redemption basket). The authorized participant can then sell the securities in the redemption basket (which were worth more than the ETF shares that they were swapped for) on the secondary market for a profit. As a result of this process, the number of ETF shares outstanding decreases, as the ETF shares delivered to the fund provider are taken out of circulation, collapsing the discount.

Is Primary Market Liquidity Just a Mirage? While individual investors don't get involved in the business of ETF creations and redemptions, it is still important to be familiar with the process in order to truly understand ETF liquidity. A critical takeaway is that the number of ETF shares outstanding is dynamic and will wax and wane according to supply and demand in the marketplace. This distinguishes ETFs from stocks and closed-end funds, which tend to have a finite number of shares outstanding. The creation and redemption feature of ETFs represents a unique source of liquidity.

Given that there are two levels of liquidity available to ETFs, daily trading volume and bid-ask spreads on the secondary market aren't necessarily the best gauges of their liquidity, as they might be for stocks. Rather, it is the liquidity of the underlying securities that tends to be a more important factor for determining ETFs' true liquidity, since that is what determines how easily an authorized participant could go to the capital markets to buy or sell those securities in order to create or redeem new shares in an ETF.

It is also worth pointing out that a single ETF will likely have several authorized participants assigned to it, which is good for investors as it promotes competition. This means an authorized participant won't sit back and let a huge premium or discount develop in an ETF or post persistently wide bid-ask quotes in an effort to fatten potential profits, because if they wait too long, then another authorized participant will step in ahead of them to capitalize on a premium or discount or quote a narrower spread.

A better understanding of the behind-the-scenes operations of ETFs could give investors more comfort when buying and selling ETF shares on the secondary market. After all, it's this "hidden" source of liquidity that ensures ETFs operate efficiently and track their benchmarks tightly in the secondary market.

A version of this article ran on Morningstar.ca on May 16, 2013.

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