ETF or exchange-traded funds are similar to mutual funds in some ways, but its main distinction lies in the fact that in ETFs, the exchanges take place in the form of common stocks. The price of an ETF’s share will rise and fall throughout the day, which means that they are much more volatile than mutual funds. Therefore, in the case of ETFs, the return will depend on the volume of stocks, leading to higher returns in case of higher volume and vice versa.
To understand the liquidity factor in exchange traded funds, you need to understand the following factors.
ETF is not a stock
Most investors appreciate ETFs due to the higher liquidity. However, there is a misconception that if an ETF does not trade a fixed number of shares a day, it will remain illiquid. This would have been true if the source of ETF’s liquidity was single. However, there are two sources for ETF liquidity, namely, primary and secondary liquidity.
Primary Market vs Secondary market
Now that you know what is ETF, you need to understand the distinction between the different markets for ETF trade. Non-institutional investors generally invest in secondary markets for ETFs. In secondary markets, investors are simply trading the stocks that already exist. The number of ETF shares traded determines secondary liquidity.
However, primary liquidity is determined by the efficiency of redeeming or creating shares for exchange-traded funds.
Another important distinction between primary and secondary liquidity for ETFs is the participants in the two cases. For the secondary market, investors compete and bid with each other or a market maker. In the case of the primary market, the investors take advantage of an authorized participant or AP to increase or decrease the number of ETF shares available in the market.
Furthermore, the determinants for primary and secondary liquidity of ETF are also different from one another. In the case of secondary liquidity, the determining factor is the price of the ETF shares traded. However, for primary liquidity, the function of the underlying shares acts as the determinant.
A person trading thousands of shares as exchange-traded funds can use an AP to increase the number of shares available, as a way to avoid the effects of an illiquid market. However, since most people do not trade thousands of shares at once, investors are generally stuck navigating the secondary market only.
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