ETFs possess two different types of liquidity, making them more easily tradable. First, ETF shares are bought and sold like a stock on an exchange. Second, ETFs possess an underlying liquidity due to their unique creation and redemption process.
Visible Liquidity (Secondary Market)
ETF shares are bought and sold on an exchange. The resulting average daily volume of shares traded between buyers and sellers in the secondary market contribute to an ETF’s liquidity. However, while trading activity is the most visible to investors, it is not the only source of liquidity for ETFs.
Liquidity From Underlying Securities (Primary Market)
Most of an ETF’s liquidity comes from its underlying securities, due to their unique creation and redemption process. Demand for stocks in the underlying portfolio drives the price. The supply of ETF shares is not fixed and can expand or contract daily. Thus, large orders are either filled with outstanding shares or, when necessary, by creating or redeeming shares.* As a result, the ETF’s assets under management (AUM), bid-ask spread, or average daily volume (ADV) will not reveal the true liquidity available for an ETF transaction.