This uncertainty could harm the ability of active ETF market makers to arbitrage efficiently and increase the fund’s adverse selection cost (see Clarke & Shastri, 2001). Exchange traded funds (ETFs) provide access to a diversified portfolio of securities such as stocks or bonds. They are flexible investment vehicles that can be used within a portfolio in many ways to meet different investment needs and objectives. 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.

The concept of liquidity in ETFs extends beyond the traditional understanding applied to individual stocks. It is a multitiered framework involving both the dealer and secondary markets. In the primary or dealer market, liquidity is facilitated through the creation and redemption mechanisms. This unique process allows for adjusting the ETF’s supply to meet investor demand, maintaining price stability.

Considering the autocorrelation of the index return, we show that the non-trading probability is positively related to the increase in the ETF variance with respect to the NAV variance. In other words, the derived equation shows that the ETF return variance can be expressed as the sum of the NAV return variance and the additional term caused by infrequent trading of the ETF security in the secondary markets. Furthermore, our empirical analysis confirms that non-trading probability is positively related to the variance difference between ETF returns and NAV returns. These results suggest that investors investing in illiquid ETFs could bear additional unnecessary risk arising from the secondary market trading instead of investing directly in underlying portfolios or similar mutual funds. US exchange-traded funds (ETFs), introduced in 1993, have grown significantly in recent years. At the end of 2016, their market size was about $3 trillion, accounting for nearly 30% of the dollar trading volume and 23% of the share volume in US stock markets.

In essence, the liquidity of the underlying holdings of an ETF directly impacts the ETF’s liquidity. A well-structured ETF with liquid underlying assets can better adapt to market demand changes, preserving fair prices and an efficient investor trading experience. When investors want to sell their GreenTech ETF shares, a fluid redemption process supported by the liquidity of the underlying holdings helps ensure that the excess supply of ETF shares is efficiently absorbed.

Reprint of: Market liquidity in the financial crisis: The role of liquidity commonality and flight-to-quality

Hamm (2014) hypothesizes a feedback loop to explain how diversification can reduce an ETF’s liquidity. Pastor et al. (2020) document a trade-off between a portfolio’s diversification and the liquidity of its underlying stocks, and argue that a more diversified portfolio tends to invest more in illiquid stocks. Underlying liquidity is transmitted to ETF liquidity through the creation/redemption mechanism.

Factors that influence ETF liquidity

We attribute this finding, which contrasts with that for passive ETFs, to uncertainty about the future holdings of active ETFs. We show that the gap between active ETF and underlying liquidity varies cross-sectionally and over time and can be explained by differences in size and volume between ETFs and their underlying portfolio, by ETF age, %KEYWORD_VAR% and by ETF pricing errors. Only a few studies analyze the effect of liquidity on ETFs, although the literature on ETFs is growing (Madhavan, 2014, Ben-David, Franzoni, Moussawi, 2017). For example, Borkovec et al. (2010) report that a sharp increase in the bid-ask spread leads to failure of ETF price discovery during the Flash Crash.

Vanguard Total Bond Market…

ETF creation and redemption is aided by tapping into the liquidity of an ETF’s underlying portfolio of securities. The purpose of these transactions is to create liquidity in the primary market and ensure that the ETF’s price very closely reflects the price of its underlying assets (via arbitrage opportunities). For example, if the price of an ETF became cheaper than the sum of its parts, the authorized participant could redeem the ETF and sell the components at a profit.

Factors that influence ETF liquidity

Returns and liquidity of illiquid ETFs are more sensitive to underlying index returns or ETF market liquidity, or both. The ETF variance could be larger than its net asst value variance owing to infrequent trading. In summary, illiquid ETFs are more likely to deviate from their underlying indexes and could be riskier than underlying portfolios.

The lack of liquidity in non-popular ETFs could prevent market makers from developing proper markets and, consequently, increase transaction costs for ETF investors. This study sheds light on secondary market liquidity issues by examining how ETF liquidity affects the price formation of ETFs, especially relative to their benchmark indexes or net asset values (NAVs). Exchange-traded funds (ETFs) are among the most successful financial innovations of recent decades.

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. We provide guidance with ETF comparisons, portfolio strategies, portfolio simulations and investment guides. Each of these players has a distinct role, and their collective actions contribute to the liquidity and overall efficiency of the ETF market. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology.

Is the tracking error time-varying? Evidence from agricultural ETCs

To examine this possibility, we use three different proxies for diversification. ETFs have become enormously popular among individual investors, but there are many risks to consider when buying or selling them. Liquidity can limit an investor’s ability to buy and sell without influencing the market price in an unfavorable way. In general, individual investors should stick to larger ETFs with high trading volumes and tight spreads to minimize their risk, while also making sure that the ETF’s holdings aren’t obscure or illiquid securities.

Exchange Traded Fund (ETF)
An ETF is an open-ended fund that provides exposure to underlying investment, usually an index. Like an individual stock, an ETF trades on an exchange throughout the day. Unlike mutual funds, ETFs can be sold short, purchased on margin and often have options chains attached to them. On a high level, liquidity in the primary market is tied to the value of the ETFs’ underlying securities, whereas in secondary market it’s related to the value of the ETF shares traded. In the secondary market, ETF liquidity is most affected by market makers that are responsible for “making a market” for the security.

Informed short selling, fails-to-deliver, and abnormal returns

They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise and investors may get back less than they invested.

Factors that influence ETF liquidity

Any examples used in this material are generic, hypothetical and for illustration purposes only. Morgan Asset Management, its affiliates or representatives is suggesting that the recipient or any other person take a specific course of action or any action at all. Communications such as this are not impartial and are provided in connection with the advertising and marketing of products and services.

A very rough measure of diversification as the number of holdings hence remains constant. For active ETFs, fund sponsors or managers do not need to track any index; therefore, they are free to choose the level of diversification for their portfolio. But the key point is that both primary market and secondary market liquidity play a role in providing a full picture of ETF liquidity. 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.

Data and variables

Bid-ask spreads are a key measure of the liquidity of an asset or security. Section 4.1 compares the liquidity of ETFs with that of their underlying components. Section 4.2 measures and explains the effect of diversification on active ETF liquidity. In Section 4.3, we attempt to explain the liquidity difference by discrepancies in various trading characteristics and ETF-specific characteristics. Knowing more about liquidity in the primary and secondary markets may help you evaluate ETFs more strategically. No, only APs are allowed to transact directly with the ETF issuer to create and redeem shares.

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