Where do ETFs get their liquidity?

It's a common misconception that an ETF's liquidity is best gauged by its average daily volume (ADV).

The reality is more complex. That's because ETFs get most of their liquidity from sources other than their trading activity on the stock exchange. Most important of these is the liquidity from an ETF's underlying portfolio of securities. The main sources of ETF liquidity are:

 

Visible liquidity on the stock exchange

The most visible source of ETF liquidity is the trading activity of buyers and sellers in the secondary market that takes place on an exchange. Trading volume is a measure of this activity, but it doesn't indicate an ETF's total liquidity.

The natural liquidity of ETFs trading in the secondary market is enhanced by exchange-registered traders called market makers. Market makers help maintain a fair and orderly market by selling ETF shares to potential buyers and by buying ETF shares from potential sellers.

 

"Hidden" liquidity on the stock exchange

Not all of an ETF's liquidity in the secondary market is easy to see. If you're a typical investor, your "on screen" view is probably limited to what's available through public financial websites. This means you'll have access to an ETF's highest bid and lowest ask, but you won't be able to see all the quotes in an ETF's order book. These quotes are another source of ETF liquidity because they represent additional prices at which ETF shares can be traded.

 

Liquidity from underlying securities

The key to ETF liquidity lies in ETFs' open-ended structure. Unlike single stocks, which generally have a fixed supply of shares, new ETF shares can be created and existing shares redeemed based on investor demand. This unique process allows ETFs to access the liquidity of their underlying securities. The result is that investors can often trade ETFs in amounts that far exceed an ETF's ADV, without significantly affecting the ETF's price.