In this BetaShares Academy post we look at one of the most misunderstood concepts relating to ETFs – liquidity. To understand ETF liquidity, we need to dig into the concept of an “open ended” fund – and when we do, it becomes obvious why ETFs are typically described as having the same level of liquidity as the underlying assets of the fund.
ETFs invest in shares or other assets (depending on the type of ETF you own) and use a flexible “open ended” system to increase or decrease the fund size – depending on investor appetite. To understand ETF liquidity, we need to dig into the concept of an “open ended” fund – and when we do, it becomes obvious why ETFs are typically described as having the same level of liquidity as the underlying assets of the fund.
“Open ended” funds
An “open ended” fund simply means that the fund can create new units when new investors come into the fund. As such, there is no maximum limit on the size of an “open ended” fund – it can grow as large as incoming investors’ money permits.
ETFs are “open ended” funds – just like most traditional, unlisted or unquoted managed funds. In an ETF, when demand for fund units exceeds the supply currently available on the stock exchange, new units are created for so-called “authorized participants” to on-sell on the ASX to meet this demand. When this happens, the fund uses the money the authorized participants have paid for the units to buy more shares (or other assets). As a result, both the total value of the fund, and the number of units on issue, increase.
This process of creation of new units also works in reverse: if the supply of fund units on the ASX is greater than demand, the ETF provider will “redeem” the excess units (being held by authorized participants). When a redemption occurs, the ETF will sell down a portion of the shares (or other assets) which the fund owns to generate cash to pay the redemption amount. When the ETF redeems units it cancels them. When this happens, both the total value of the fund, and the number of units on issue, decrease.
Note that only authorized participants, which are certain types of financial institutions, are normally able to apply for, or redeem, units directly with the ETF. All other investors can buy or sell units in the ETF by trading on the stock exchange.
ETF liquidity compared to liquidity of underlying assets
Understanding this ‘creation and redemption’ process is key for investors to transcend one of the most often misunderstood parts of ETF trading – one of the most common mistakes made by beginner ETF investors is to incorrectly assume that the liquidity of ETFs is limited to the ‘on screen’ liquidity at any given time of the day.
As described above, an ETF issuer can create or redeem units whenever there is a mismatch between the supply and demand on the ASX. When the ETF issuer creates or redeems units they will be buying or selling the underlying shares or assets which back the ETF. Hence, the liquidity of the ETF is potentially as good as, and is limited only by, the liquidity of the underlying shares or assets.
Using the example of BetaShares FTSE RAFI Australia 200 ETF (ASX: QOZ) we can show the difference between ‘on screen’ and ‘actual liquidity’. At the time these screenshots were taken ‘on screen’ liquidity was approximately $3.3m, whereas the average daily traded value of the underlying constituents was approximately $4.3b (Source: Commsec, Bloomberg)