Authored by Wade Guenther, Will Cai, Alexander Chang
Exchange-traded funds (“ETF” or “ETFs”) have been around for a few decades. However, there are still questions around ETF liquidity that are causing hesitation when it comes to ETF investment and trading, particularly with ETFs that have low trading volumes. Below is a deep dive into ETF liquidity that examines various common metrics and how they apply to ETFs. We will address how some of these metrics can be misleading for ETFs, especially as they relate to newly launched ETFs. Throughout the discussion, we will examine and compare a newly launched hypothetical gold ETF versus a hypothetical larger, more established, gold ETF.
Trading Volume – A Topical Measure
Many people use trading volume, which can be the number of shares traded, or average daily volume (“ADV”), as the primary indicator of liquidity. Trading volume can be easily obtained and can be used as a quick gauge of liquidity, but it has major drawbacks. Trading volume, generally, is a historical measurement of how many shares were traded, not necessarily how many shares can be traded currently. An extreme example would be that for a stock early in the trading day with zero shares traded but with 100,000 shares on both bid and offer (100,000 x 100,000), meaning one could buy or sell 100,000 shares easily. The stock’s liquidity certainly was not zero as its trading volume would be indicating.
On a trading day, the hypothetical new gold ETF traded a total of 2,000 shares with a closing price of $17.78, for example. The larger hypothetical gold ETF could trade millions of shares a day. Let’s assume it traded 7 million shares with a price of $150.00, then it could suggest that the larger hypothetical gold ETF was about 30,000 times more liquid than the hypothetical new gold ETF, in dollar terms.
Order Book – A Better Measure
Bids and offers are part of the order book, where one can buy or sell stocks and ETFs in the secondary market. Retail customers often only see the national best bid and offer (“NBBO”), aggregated across all trading venues and market participants.
National Best Bid and Offer Example
For example, investors may see the hypothetical new gold ETF bid and offer at 3 x 3 lots, which means 300 shares were available at the best bid and offer (each lot is 100 shares).
However, best bids and offers are only one level of the order book. Level II order book data could reveal bids and offers at different prices levels, which often shows more liquidity.
In the example above, 3 lots of the hypothetical new gold ETF were bid at $17.80 and 30 lots at $17.79. The bids and offers represent market liquidity that one can easily buy and sell with a click of a button, even if trading volume was zero. Furthermore, there could be hidden liquidity that isn’t reflected in the order book as market participants could enter a very large order but only display a small portion of the order to not show their hands.
Below is a sample comparison of the hypothetical new gold ETF and the hypothetical larger gold ETF’s order books:
From this snapshot, the hypothetical new gold ETF’s order book shows liquidity of 3300 x 3300 shares with a total dollar amount of approximately $120,000 available for trading. The hypothetical large gold ETF’s order book shows liquidity of 4500 x 3800 shares with a total dollar amount of approximately $1,200,000 available for trading. The hypothetical large gold ETF order book liquidity, in this example, was about 10 times more liquid than the hypothetical new gold ETF.
So far, our discussions on liquidity measures using trading volume and order book apply to both regular company stocks and ETFs. However, while one could trade ETFs just like stocks, ETFs offer a significant difference and advantage versus stocks when it comes to liquidity.
Implied Liquidity – Creations and Redemptions
A company stock usually has one primary issuance, the Initial Public Offering (“IPO”), then the stock trades on secondary markets, which are the stock exchanges. ETFs are different because ETFs have the creation and redemption process that allows daily and direct access to the primary market, which is the ETF sponsor. The direct access to continuously create (buy) and redeem (sell) ETF shares at fair market prices (at daily Net Asset Value) represents a significant source of liquidity for ETFs.
A market maker, who provides liquidity to the secondary market by quoting two-way prices, usually needs inventory of ETF shares to satisfy potential buy orders. However, when an ETF market maker1 has a large buy order and not enough ETF shares in supply, they could access the ETFs primary market. The market maker could create ETF shares with the sponsor for the amount needed and purchase the ETF’s underlying holdings to hedge. The market maker will deliver the underlying ETF holdings to the sponsor and receive the ETF shares in return. This ability to create and redeem directly from the sponsor means an ETF’s primary market liquidity can be limited only by the liquidity of the ETF’s underlying holdings, which is the implied liquidity1. However, disruptions in the ability to create or redeem ETF units may adversely affect investors.
In the hypothetical new and large gold ETF examples, the order books seem much less liquid for the hypothetical new gold ETF. However, both ETFs represent an investment in physical gold bars, and both ETFs offer daily creation and redemptions. The implied liquidity should be exactly the same for both as they are limited to the liquidity2 of the underlying physical gold in the ETFs and closely related hedges, i.e., gold futures.
According to the LBMA, the 12-week moving average of physical gold turnover was $290 billion as of June 20, 20213. That equates to an average daily physical gold turnover of $4.83 billion. Further, CME COMEX gold futures have often been considered one of the most liquid commodity futures. CME COMEX gold futures offers quick and efficient hedging to physical gold for market participants that do not have direct access to physical gold trading. According to the World Gold Council, 2020 total gold liquidity ranked between U.S. Treasury Bills and the S&P 500® Index4.
Conclusion – Deep ETF Liquidity
A newly issued ETF, hypothetical like our example or otherwise, may appear to have low liquidity as measured by trading volume or even by the exchange bids and offers in the order book, but it can have massive liquidity support through the ETF creation and redemption process that equals the liquidity of the largest physical gold ETF in the U.S. The high gold liquidity means that for a newly launched gold ETF, even though it has limited exchange trading activity, investors, through Authorized Participants (“APs”), can trade a significant number of ETF shares at fair market values on a daily basis.
 Often implied liquidity of an ETF (through the primary market) could be much larger than the liquidity reflected in its exchange order book (secondary market).
 For ETFs holding multiple underliers, the implied liquidity would be the liquidity on the least liquid underlier within the ETF.
 LBMA Weekly Turnover
 World Gold Council Trading Volumes
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