ETF Liquidity and Trading

1True Liquidity of an ETF

Many investors wrongly assume that the daily trading volume of an ETF is the definitive indicator of its liquidity. But what is generally used to determine a stock’s liquidity, i.e., average daily trading volume, cannot necessarily be applied to ETFs. In the world of ETFs, trading volume does not necessarily indicate the liquidity of an ETF - minimal trading activity does not necessarily mean wider bid-ask spreads, greater costs or no buyers for sellers. ETF liquidity is primarily a function of the liquidity of its underlying basket of securities, that is, the securities in the benchmark that it tracks – true ETF liquidity is based on the volume of the component securities.

ETFs utilize a creation and redemption mechanism which allows market makers to tap into highly liquid underlying holdings to create or redeem ETF units at the end of each trading day so as to remedy supply and demand imbalances in the market and to mitigate the price impact of any single trade. (See Creation/Redemption and Arbitrage) The deeper and more liquid the underlying index or benchmark, the more efficiently priced the ETF.

2Best Trading Practices

Once you have chosen the ETFs that are right for your portfolio, you are ready to purchase units of the ETF. To do so, you can use a full service or discount/online broker in the same way you would to purchase stocks. You can buy or sell ETFs any time the stock market is open – ETFs are traded throughout normal trading hours at the then current market price. ETFs have ticker symbols just like stocks. Generally, you are able to use the same order types as you would for a stock purchase or sale, including market, limit, stop limit, day and good til cancelled (GTC) orders. The purchase of ETFs can be executed in either a cash or margin account, and in either a registered or non-registered account. If you plan on selling ETFs short, those trades must be done in a margin account.

It can be best to avoid market orders and instead use limit orders. A market order is the default order. It attempts to complete your trade as soon as possible at the best available current price. A limit order allows you to set a maximum price when you buy and a minimum price when you sell. It allows you to buy up to a specified number of shares or units of an ETF at a specified price. This is a useful tactic when trading in a highly volatile market or when trading a low volume ETF which might have a wider bid-ask spread. This approach could provide a better sense of where your trade would get filled. In Canada, market makers are assigned to each security listed on a senior exchange in order to maintain minimum spreads and guarantee fills.

It is generally best to trade ETFs as close to the time zone as trading in their underlying assets in order to minimize tracking errors and premiums/discounts and be able to gain access to the most liquidity. It is therefore wise to trade ETFs when the market for the underlying basket is open. For example, if trading in Canada an ETF with European stocks in the underlying basket, it is wise to trade that ETF in the morning trading hours. Any time a market maker cannot buy the underlying stocks in real time, this could result in wider bid-ask spreads or greater premiums or discounts to NAV.

Caution should be taken during the first few minutes of the trading day and the end of the day as these tend to be the most volatile trading times. In the morning ETFs are going through an adjustment phase where the previous day’s closing price is being compared to the current value of the underlying securities. Also, some securities in a particular basket may not begin trading the moment the market opens, and in those cases market makers need to estimate fair value and may need to widen their spreads until they have better price discovery. Similarly, at the end of the trading day, hedging activities undertaken by market participants can result in rapid pricing changes and wider bid-ask spreads. Toward the end of the trading day a number of stocks become less liquid because they are not as actively traded and this reduced price discovery translates into wider spreads on the ETF.

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