ETF ACADEMY: ETF Liquidity Part 1

ETF LiquidityCNBC reported this morning that holders of Auction Rate Preferred securities (see Nuveen’s for a good overview) were having problems getting their money out of their investments. In the investing world, the ability to get your money out of an investment is called liquidity.

Since ETFs are a way to invest, liquidity is an important consideration. Is ETF liquidity a major consideration? What determines ETF liquidity? To answer that question, you should understand what an ETF is and where ETF shares come from.

The vast majority of money in ETFs are in funds that track a major equity index (a group of stocks) by actually buying shares of the companies that are in the index. Most ETFs are open-ended, that means that there is no fixed number of shares. As money comes into an ETF, the market maker simply creates new shares and then invests the money into the shares of the companies that make up the index.

The same is true for when money flows out of an ETF – the market maker will sell the shares of the underlying companies and eliminate the appropriate number of ETF shares.

So the ability to put money in or take money out of an ETF, the ETF’s liquidity, is not determined by the number of ETF shares that are traded in any one day. Liquidity is a function of how easy it is for the market maker to buy or sell the ETF’s underlying securities.

ETFs that track the indices of the largest and most actively traded public companies will be the most liquid. Examples include State Street’s SPDR S&P 500 ETF (Amex: SPY) and Dow Diamonds (Amex: DIA), PowerShares’ QQQ (Amex: QQQQ), and Barclay’s iShares S&P 500 Index Fund (Amex: IVV).

ETFs that track indices of equities with lower trading volumes will be less liquid by definition. We’ll cover those ETFs as well as ETFs tied to other securities in ETF Academy: ETF Liquidity Part 2.

To learn more about the technical underpinnings and empirical evidence on ETF liquidity, we recommend an article by Salomon Smith Barney’s Kevin McNally “The Truths About ETF Liquidity and Pricing“.

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