True ETF Liquidity

Editorial Note: There are hidden costs to investing. One of them is the bid-ask spread. That is the difference between the buying and asking prices. If it is an illiquid investment, that spread is larger. You might openly pay more to broker the deal, like you see in real estate. Or it can be more insidious, like when you are trading low-volume stocks. How does that apply to ETFs? Are lower-volume ETFs liquid? I have gotten that question from readers and asked it myself. The answer requires a deep dive into how ETFs work. Fortunately, I have decided to collaborate with an expert. Learn how ETF liquidity works and three best practices to help you get the best price.

This is a paid sponsor post. You will see relatively few of these on The Loonie Doctor because my mission is the priority of this site. Sponsored posts must align with that and the sponsor provides a service or product that I would use myself or recommend to a family member. One that I like. I retain editorial control, and the articles are written to be educational as the primary objective. It is a win-win because you get deep content written by industry experts, but vetted by me. You can read more about why I decided to collaborate with BMO ETFs as a sponsor, but I think you’ll get it after reading this post.

The True Liquidity of ETFs

By: Danielle Neziol, VP, BMO ETFs

One of the most common questions we get from investors is, “If a certain ETF doesn’t trade often, or has low trading volume, will I be able to sell the ETF when I need to?” The quick answer is yes you can, and I’ll explain why.

This liquidity concern makes sense when we think about trading stocks. A stock that is thinly traded will be much less liquid than a highly traded large-cap, blue-chip stock. Therefore, the less liquid stock could be difficult to sell if there is no demand. However, ETFs work differently than stocks in this regard.

The true liquidity of an ETF has three layers. These three layers are something investors can’t easily see. In fact, most volume data available to investors online is only showing the tip of the liquidity iceberg. Let’s peak beneath the surface at each of those layers.

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Natural Liquidity

The first layer that most investors are familiar with is between the natural buyer and the natural seller, who get matched on the exchange. Think of this like going to Facebook Marketplace or Kijjiji to sell your car. These marketplaces will match a buyer with a seller. Both will agree on a predetermined price and the transaction is made.

This layer of liquidity is mostly present among the largest and most liquid ETFs in the market (usually those with a billion or more in assets).

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Market Makers

The second layer of liquidity uses market makers. Market makers are dealers or brokers who hold an inventory of ETFs and will either buy ETFs or sell ETFs depending on supply and demand. A market maker is trade agnostic which means they are always willing to buy and sell. They make their money in trading volumes (earning commissions on each trade).

This would be like going to a car dealership to buy or sell a car. The dealer acts as a market maker, who will buy your car and sell it to someone else. They usually earn a spread, their profit, on this transaction. Market makers are often who you will “meet” on the other end of your ETF trades and they play a huge part in a healthy and liquid ETF ecosystem.

Fortunately, unlike a car dealer, the volume for even a small ETF is much higher than car sales. They also don’t have the extra overhead costs of a Fly Guy to advertise with. So, the spread per trade can still be relatively low. More on that later.

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Creations & Redemptions

The third layer of liquidity is called the Creation and Redemption Process. ETFs have this ability because they are open-ended funds. That means that they can add or take away units of the fund to accommodate net money flowing in or out. The process occurs when there is an imbalance in supply or demand for a specific ETF.

Creations

If demand is high, there will be more creations. This means the ETF provider (for example, BMO ETFs) will create more shares of an ETF to match demand. This is simply done by purchasing the stocks that the ETF holds, turning it into an ETF, and then passing it on to the buyer.

Redemptions

If supply is high and demand is low, there will be more redemptions. This means that the seller will send their ETF back to the ETF provider. The provider will disassemble it and sell the underlying stocks in the market, sending cash back to the ETF seller.

Think of this process like ordering a car directly from the auto manufacturer. They will go and buy all the parts for the vehicle, build it, and deliver the car to you. A redemption would be the opposite, where a car would be sold back to the auto plant and disassembled and sold off for parts. This is, of course, not how things are done in the auto world but a good example to visualize the process! The big difference from a car is that the parts are worth the same whether already used in the car or not. [Editorial Note: Kind of like a LEGO® car, except without the dangers of stepping on the pieces on the floor in the dark].

This last layer of liquidity is important to understand because it demonstrates that an ETF is as liquid as its underlying holdings of stocks or bonds.

ETFs Bring Liquidity to Less Liquid Asset Classes

Because of these three layers of liquidity, an ETF can sometimes be more liquid than its underlying holdings. We typically see this in less liquid asset classes such as preferred shares and fixed income. Those markets have more friction, and the ETF will be easier to trade than the underlying holdings.

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Da’ Bomb for Trading Bonds

For example, the bond market trades over-the-counter (OTC), not on the open exchange. This means to buy or sell a bond an investor must use a dealer to facilitate the transaction, and the pricing of each bond is hard to find and often tricky to determine. Fixed income is a huge opportunity for ETFs because it provides an OTC asset class with greater transparency and tradeability on the exchange instead. That means tighter spreads.

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When Bond Markets Froze & ETFs Did Not

A wonderful example of these features and benefits was readily apparent during March 2020. The market suddenly crashed as investors scrambled to make sense of a growing pandemic and ensuing economic shutdown. The bond market, in particular, completely froze as pricing became impossible to determine and market makers could not take on risk.

In contrast, during this time, fixed-income ETFs remained available and continued trading when the underlying bonds were not. This had a major practical implication. As equity markets were down so drastically into the first quarter end of 2020 and bond prices held steady, investors needed to rebalance. This is exactly why you hold bonds as part of your asset allocation!

Investors needed to raise capital by selling fixed-income investments to rebalance and buy equities at a discount. The ETF market was one of the best places to actually raise cash. Simply because the ETFs continued to trade while many of the underlying bonds did not.

This real-life example highlights how well ETF liquidity works. During an extremely stressed market, fixed-income ETFs continued to trade and provided liquidity for those who needed it. We can’t overstate enough the importance of liquidity when it is needed most. ETFs, while still subject to market volatility, provided liquidity during the March 2020 correction.

Misleading ETF Trading Volume

Hopefully after reading the first section of this post, you understand that the trading volume of the ETF is really what matters to its liquidity. The three layers of liquidity keep the friction low. It is the liquidity of the underlying holdings that matters. Still, if you want to find the trading volume for ETFs, the data itself is often misleading.

The Toronto Stock Exchange (TSX) is just one of seven different exchanges in Canada where ETFs trade every day. In fact, only about 35% of all ETF trading volume trades through the TSX. The three largest exchanges are the TSX, NASDAQ, and CBOE Canada. (source: CBOE Canada October, 2023).  When looking at ETF volume metrics online, many stats published are only capturing the TSX data stream. That means 65% of the volume is unaccounted for.

If you do care about ETF volume, then there are more robust data sets, such as quotemedia.com. A quote that shows the ETF trading volume on all the exchanges is called a consolidated quote.

Understanding the Bid-Ask Spread

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Tight & Wide Spreads

Because ETFs trade on the exchange, they have a price quote attached to them as they trade during market hours. An individual looking to sell will receive the bid price. Another individual looking to buy will pay the ask price. The difference between the two is called the bid-ask spread. This spread is part of an ETF’s transaction cost. The spread will also tell an investor how liquid the ETF is.

A spread of just a few pennies wide is called a “tight spread”. This indicates a very liquid ETF. Spreads wider than 10 cents are “wide spreads” and indicate a less liquid investment. Market makers are responsible for posting the spreads. They are the capital market participants who earn the spread cost for facilitating the transaction.

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Trading Risk & Bid-Ask Spreads

There is a relationship between spreads and the trading risk born by the market makers. They must get compensated more when they take more risk. For example, ETFs that hold non-North American securities may have wider spreads than ETFs holding Canadian and American securities. This is because the international-market ETF listed in Canada trades during Canadian market hours while its underlying stocks might be from markets in Asia or Europe. Those foreign markets are closed during most of the Canadian trading day.

Therefore, the Canadian-listed ETF would be harder to price for a market maker given much of its underlying is trading in a market that is closed. Another example would be an ETF that is holding small-cap securities, or stocks that are thinly traded. Those ETFs would typically post a wider spread than an ETF with large cap highly liquid securities as its underlying holdings. Again, the liquidity of an ETF is related to the liquidity of the underlying holdings.

ETF Trading Best Practices

Now that you understand how ETF liquidity works, apply that to how you buy or sell ETFs. Here are some best practices.

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Avoid trading on the open & close of the market.

As the market price of an ETF is a reflection of the underlying portfolio’s value, avoid trading in the first 10 minutes of the day. This allows enough time for the underlying portfolio to start trading. Similarly, avoid trading into the close, as underlying portfolio movement can be volatile at the end of the day. In Canada, the market is open from 9:30-4:00 EST, and is closed on most holidays.

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Always use limit orders.

As with trading equity securities, many order types are available for use. The entry or exit trading price will impact the trade’s overall profitability. To avoid any unwanted surprises, a limit order can ensure a desired price on the trade. It’s important to note that if the market moves away from a limit, an investor may consider revisiting the limit price.

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Trade when the underlying market is open.

The market maker will be able to keep a tighter spread when the underlying portfolio is trading, as the ETF’s price can be precisely calculated. When the underlying market is closed, the market maker will have to model the price, and will therefore set a slightly wider spread to reflect their increased risk on the trade. Where possible, for international ETFs, trade when the underlying market is open. For Canadian-listed ETFs this would generally be early in the morning if looking at ETFs with European or Asian equity exposure. And for ETFs with U.S. equity exposure, be mindful of U.S. holidays where the Canadian market is open, but the U.S. market is closed.

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Avoid trading around large announcements.

As the pricing of the stock market is a real-time reflection of all the information we have that is publicly available, be mindful of trading around large public announcements that may have a material impact on an ETF’s price. For example, economic announcements such as Bank of Canada rate decisions or inflation reports, or political announcements such as updated policy or international election results.

ETF Liquidity & Market Makers Video

If you would like to learn more on this topic in a different format, check out our ETF Market Insights Episode on Liquidity and Market Makers. It is one of many videos that we’ve made on ETF investing topics on our YouTube channel.

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