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Over the coming year, the Canadian ETF Association (CETFA) will try to debunk many of the myths surrounding the ETF industry in an effort to educate advisors on the mechanics and use of ETFs. The first and most common myth raised by advisors is that buying an ETF with low trading volume is dangerous because there is a lack of liquidity and your trade could possibly move the price.

In fact, unlike shares in a publicly listed company, ETFs do not have a fixed number of units outstanding. They are open-ended, like mutual funds, enabling new units to be created on demand to support interest from small do-it-yourself investors as well as large institutional clients. Therefore, they are not subject to the same supply-and-demand liquidity profile.

Understanding the liquidity of an ETF is more complex than just looking at the trading volume on your screen. With an ETF there are two levels of liquidity: primary and secondary.

An ETF’s trading volume on an exchange is its primary liquidity. When you look at an ETF’s trading volume, you’re likely seeing the trading data from only one exchange – which could be very misrepresentative of the total trading volume from all marketplaces. Canada has two exchanges that list ETFs, the TSX and NEO, but there are, in fact, 12 other markets that trade the same securities. While TSX and NEO data get to your terminal in real time, the other markets’ information is not consolidated into your terminal.

Many believe that if an ETF does not trade a certain number of shares per day — for example, 50,000 shares — the fund is illiquid and should be avoided. This may be true from a single-stock perspective, but with ETFs, you need to look deeper. This is the key is to understanding the difference between the primary and secondary liquidity of an ETF.

Secondary liquidity is the liquidity of the underlying basket of securities that an ETF portfolio represents, which is captured through the creation/redemption process. One of the key features of ETFs is that the supply of shares is flexible — shares can be created or redeemed to offset the changes in demand. Liquidity in one market — primary or secondary — is not indicative of liquidity in the other market.

This structure has two important functions:

  • it creates liquidity for the ETF shares by meeting the supply-and-demand needs of investors who trade on an exchange; and
  • it helps keep an ETF’s price per share close to the ETF’s net asset value (NAV).

This is the most important layer, as the underlying stocks in the portfolio of an ETF determine the price (often referred to as the spread) at which an investor can buy or sell the ETF.

In fact, there are many aspects to defining the liquidity of an ETF, including the bid/ask spreads on the securities held in the portfolio, how easy is it to buy or sell the underlying securities without impacting their price and the depth of the order book to handle interest from investors — in other words, the volume of pending orders for the ETF.

If an investor asks you about liquidity, remember, there are many factors that go into defining the liquidity of an ETF. First and foremost, you should look into the underlying securities that make up the ETF strategy — not just the trading volume you see on your screen.