There is a common misunderstanding when it comes to ETFs and liquidity, especially with respect to newer or exotic ETFs that track ever narrowing sectors.

Liquidity

Normally investors will take into account the average trading volume of a stock when considering it’s purchase. If there are few shares trading hands on average then it might be difficult to buy or sell a stock because there may not be enough investors willing to trade with others. If you placed a Market order, it might get filled at a dramatically different price than the last traded price – many investors have discovered this the hard way. In this case, you may want to consider a limit order and it’s possible that you may not get your order filled at all. This is why many experts will encourage you to look at the average volume of a stock before deciding to purchase it.

Exchange-Traded Fund Liquidity

As you probably know, an exchange-traded fund is normally made up of many individual securities held together in one entity that trades on an exchange. Usually these ETFs are tracking a highly recognized index. However, with the explosion of ETFs in the marketplace there are numerous strategy ETFs and sector specific ETFs which aren’t as popular as the more broad index based ETFs. These specialized ETFs can have very low daily trading volumes, some often have zero volume many days in a row. But note that this does not necessarily indicate poor liquidity for this ETF. There are special market participants who are designated to be “market makers” whose job it is to ensure that a “market is made” (duh!) for the particular ETFs in question. Really, the liquidity of the ETF is based on the liquidity of the collective underlying securities inside the ETF, and not the ETF itself.

So for example if you had an ETF which just bought an equal weighting of the top 10 stocks on the TSX, this may not be a popular ETF since it is so narrow in scope. It may have a very low average daily trading volume. But, if you wanted to buy 100,000 shares of it, it wouldn’t be much of a problem as the liquidity of the top 10 stocks in the TSX are very liquid. The market makers would ensure that the value of the ETF remained in line with the value of those 10 stocks. Arbitrageurs would make sure that the bid/asks remain relatively tight to the NAV (Net Asset Value) of the underlying portfolio of securities.

That’s Not The Whole Story

Having said this, it’s possible for the market makers to occassionally “fall asleep” as I have heard from colleagues in the field who were placing large orders for certain ETFs. As such, I tend to use limit orders even though the liquidity is ample for some of the less traded ETFs that some clients may want to use. Better safe than sorry. Note that for DIY investors, there may be extra costs associated with placing limit orders.