The Real Measure of ETF Liquidity

Exchange-traded funds have been around for decades and are a popular vehicle choice. However, a common misconception about ETFs is that those with lower average daily trading volumes (ADV) are less liquid compared to those with higher volumes. ETF liquidity refers to how easily an ETF can be bought or sold in the market without significantly affecting its price. While this concept seems straightforward, how ETFs behave when traded is far more complex.

Looking Beyond Trading Volume

Unlike a common stock with a fixed amount of available shares, an ETF's shares can be created in unlimited quantities. This flexibility is why an ETF's liquidity is not as closely linked to its ADV as a stock's would be. Instead, an ETF's liquidity is determined primarily by the tradability of its underlying basket of securities. In many cases, this structure allows an ETF to trade in amounts exponential to its ADV.

ETF liquidity providers, commonly called "market makers", can create and redeem shares directly with an ETF issuer — by interacting with the ETF's underlying basket of securities — to meet demand from investors. As a result, ETF price changes are based generally on the price and availability of the underlying portfolio rather than the ADV of the ETF itself.

Implied liquidity shows how much of an ETF can trade without causing liquidity issues in the ETF or its underlying holdings. Going beyond the ETF's ADV, implied liquidity can serve as a benchmark for the trade size an investor reasonably can execute without causing price impact to the underlying securities — and, by extension, the ETF itself.

How Does Implied Liquidity Apply When Evaluating ETFs?

An ETF's implied liquidity serves as a benchmark for the trade size an investor reasonably can execute without causing price impact to the underlying securities — and, by extension, the ETF itself.

Tradability

For both passive and active ETFs, implied liquidity offers investors a more comprehensive evaluation of accessibility, surpassing the insights provided by relying solely on ADV.

Newly Issued ETFs

Implied liquidity helps provide a more accurate assessment of an ETF with a short trading history compared to considering only ADV, which can sometimes give a false impression of low liquidity.

Trade Size

A higher implied liquidity suggests that an ETF can be traded in larger quantities without substantially affecting the market price, making it a more liquid investment vehicle.

ETF Liquidity in Practice

MFS Blended Research® International Equity ETF (BRIE) Trade

Here is a real-world, block trade example demonstrating that trade size, even when it is over 10x the 30-day ADV, does not impact the bid/ask spread.