Liquidity risk and exchange-traded fund returns, variances, and tracking errors

Our paper investigates market-level determinants of the liquidity spillover between the ETF and its underlying portfolio. Liquidity spillover shares similar market-level determinants to liquidity commonality. These findings are consistent with the “wealth effect” theory of financial contagion of Kyle and Xiong (2002), which argues that increased risk aversion in the marketplace intensifies liquidity spillover among asset classes. ETFs actually operate in a fundamentally different ecosystem to other instruments that trade on stock exchanges, such as individual stocks or closed-end funds. Whereas these securities have a fixed supply of shares in circulation, ETFs are open-ended investment vehicles with the ability to issue or withdraw shares on the secondary market according to investor supply and demand. Unlike single stocks, which have a fixed supply of shares, new ETF shares can be created and existing shares redeemed based on investor demand.

As a result, corporate bond ETFs tend to have larger premiums and discounts. There are occasions when executing a large order for an ETF may have a market impact. Under this circumstance, your ETF trading desk can be especially helpful by transacting with multiple brokers and generating a level of trading competition that can result in a favourable trade. When your objective is to place an order for the best possible average trade price over a period of time and the ETF in question is trading at a high ADV, your best option is to have the ETF trading desk work the ETF order. If the ETF you want to trade has a high average daily volume (ADV) you can execute a simple limit order through your trading site.

Exchanges give firms looking to market publicly listed securities the platform to do this. Liquidity refers to the ability to buy or sell a security quickly, easily and at a reasonable transaction cost. ETFs and individual stocks both trade on a stock exchange, leading many investors to believe that the factors that determine the liquidity of the two securities must also be similar. The choice of the index or sector tracked by an ETF can significantly affect its liquidity. If an ETF tracks a well-known, widely followed index with liquid underlying assets, it’s likely to have better liquidity. Conversely, ETFs tracking obscure or less liquid indexes may face liquidity challenges, as the underlying assets might be harder to trade, affecting the efficiency of the creation and redemption process.

When it comes to maintaining liquidity in exchange-traded funds (ETFs), authorized participants (APs) play a crucial role. APs are institutions that are authorized to create and redeem ETF shares with the fund’s issuer. This process is what allows ETFs to maintain their net asset value (NAV) and ensures that there is always a buyer or seller in the market. In this section, we will discuss the importance of APs in maintaining ETF liquidity.

Global economic policy uncertainty and the stability of cryptocurrency returns: The role of liquidity volatility

They are able to find liquidity in an ETF regardless of its average daily volume or the liquidity shown on the trading screen. Authorised participants (APs) are the institutions authorised to interact directly with an ETF manager to create and redeem large blocks of ETF shares. Market makers are broker-dealers that regularly provide two-sided (buy and sell) quotes to clients. Index providers periodically make changes to, or rebalance, their indexes.

To assess secondary market liquidity, follow an ETF at different times of day, over various time periods, and note how it’s affected by market environments. Some of the statistics you might want to focus on include average bid-ask spreads, average trading volume, and premiums or discounts (i.e., does the ETF trade close to its net asset value?). 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. Secondary market liquidity is determined primarily by the volume of ETF shares traded. This unique creation and redemption mechanism means that ETF liquidity is much deeper and much more dynamic than stock liquidity.

Spreads can widen at certain times each day or on certain days of the year. A number of factors can influence how you place ETF orders and when you should call an ETF trading desk for assistance. None of these companies make any representation regarding the advisability of investing in the Funds.

A higher ADV indicates that the ETF is more liquid, as there are more buyers and sellers in the market. However, it is important to note that the ADV varies depending on the ETF’s underlying assets and market conditions. For example, an ETF that tracks a popular index like the S&P 500 will likely have a higher ADV than a niche ETF that tracks a specific sector.

With over a billion shares per day traded last year, ETFs account for nearly one-third of all dollar volume traded on U.S. exchanges. International investing has a greater degree of risk and increased volatility due to political and economic instability of some overseas markets. Changes in currency exchange rates in different accounting and taxation policies outside the U.S. can affect returns. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility. Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors.

Illiquidity contagion and liquidity crashes

The bid-ask spread is the difference between the price at which an investor can buy an ETF share (the bid price) and the price at which an investor can sell an ETF share (the ask price). A narrower bid-ask spread indicates https://www.xcritical.com/ a more liquid ETF, while a wider bid-ask spread indicates a less liquid ETF. When the demand for an ETF share exceeds the supply, the price of the ETF share may rise above the net asset value (NAV) of the ETF.

• Liquidity spillovers increase during the market crisis, and economic downturns and are positively related to market volatility and funding constraints.
• An individual block can represent a company (Apple) or country (Mexico), but together they form an industry (technology) or a continent (Latin America).
• 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.
• Yet, in previous instances, such as the flash crash of 2010, it has been argued that ETFs propagated liquidity shocks to the underlying equities (Commodity Futures Trading Commission and Securities and Exchange Commission 2010).

In the primary market, a specific type of entity known as an “authorized participant” (AP) can change the supply of ETF shares available. The AP can offload a large basket of shares (i.e., redeem) or acquire a large basket of shares (i.e., create) directly from the ETF issuer. Typically, the AP is doing business in the primary market to meet supply and demand imbalances from the trading that happens in the secondary market. Ultimately the primary market helps provide for additional liquidity in the secondary market. In other words, shares can be “created” or “redeemed” to offset changes in demand.

Relative liquidity, fund flows and short-term demand: Evidence from Exchange-Traded Funds

ETF providers can use a range of tools and strategies to manage liquidity, including creation and redemption units, market-making, monitoring liquidity, diversification, and transparency. By following these best practices, ETF providers can help to ensure that their ETFs remain liquid and successful. The shares of any fund mentioned herein may only be marketed %KEYWORD_VAR% in Bermuda by or on behalf of the fund or fund manager only in compliance with the provision of the Investment Business Act 2003 of Bermuda and the Companies Act of 1981. Engaging in marketing, offering or selling any fund from within the Cayman Islands to persons or entities in the Cayman Islands may be deemed carrying on business in the Cayman Islands.

The real-time trading feature of ETFs provides intraday liquidity, allowing investors to execute trades throughout the trading day. Alternatively, mutual funds offer end-of-day liquidity, with all orders processed at the closing NAV. This basic difference makes the liquidity experience between ETFs and mutual funds distinct, catering to different investor preferences and strategies. Price discovery helps investors identify the proper market price of securities or other instruments based on factors like supply and demand.

Understand liquidity

Consider a basketball team, made up of key players like a point guard, shooting guard, power forward, small forward and center. Similarly, an ETF is like a “team” made up of diversified “players” like stocks, bonds and commodities that tracks against the “goal” of matching its performance to an index, such as the S&P 500. In doing so, it potentially provides more predictable returns than other investment choices. An exchange-traded fund (ETF) is a collection of assets that trades on an exchange. If the liquidity of the unpopular ETFs is insufficient, it may affect the proper functioning of the ETF market in those products with consequent increased transactions costs for investors.

Finally, liquidity spillover varies proportionally with ETF arbitrage activity and tends to be lower when short sales constraints exist. Some ETF trading activity, called over-the-counter (OTC), takes place off exchanges altogether. This activity is sometimes not reflected in the volume data provided by stock exchanges. Those market makers might have inventories or can use their balance sheet to fill ETF orders. What’s more, since ETF shares are traded directly by buyers and sellers on-exchange, an ETF can circumvent “forced selling,” something a mutual fund may need to do when investors want to sell their shares. This means that most ETF trading occurs without transactions taking place in the underlying securities.

This helps keep the price of GreenTech ETF in check, ensuring its price is closely aligned with the NAV. One day, a breakthrough invention in solar energy creates waves of excitement in the market. Investors move to buy shares of GreenTech ETF to capitalize on this trend. The sudden surge in demand could drive the share price of the ETF sky-high, deviating from the actual value of the underlying assets or its NAV. A common misconception is that ETFs with lower average daily volume (ADV) are not as liquid as others in the marketplace.