🤝Behind Every Smooth Trade: The Magic of ETF Liquidity

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Happy Sunday, ETF explorers! Welcome back to our ETF101 series, where we simplify investment jargon into easy insights. In our last edition about ETF liquidity, you learned about the basics: Assets Under Management (AUM), trading volume, and bid–ask spreads. Today, we're diving deeper—much deeper. We're going behind the curtain to reveal the hidden machinery that makes ETF liquidity truly fascinating.

Have you ever wondered why some ETFs feel "smooth" to trade while others seem "sticky"? If so, this deep dive is for you. We'll keep the tone simple, fun, and friendly—after all, this is ETF UNO!🧡

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🤔Why This Matters More Than You Think?

While basic metrics may suffice during stable market conditions, understanding liquidity becomes crucial during volatile times. This knowledge can help you avoid unexpected costs and delays, allowing for smoother trades at expected prices. It empowers you to make more informed decisions by looking beyond surface-level statistics.

ETF liquidity is mainly influenced by the liquidity of its underlying assets rather than its trading volume. Consequently, an ETF can be highly liquid even with low trading activity, thanks to “Implied Liquidity”.

An ETF can be thought of as a storefront. While the ETF itself might seem quiet or illiquid (like empty shelves), it's directly connected to a massive, liquid warehouse—the market for its underlying assets (like stocks or bonds). Because the ETF can tap into this deep pool of underlying liquidity, even niche ETFs can efficiently handle large trades. This hidden depth, known as "implied liquidity," is the real power behind the scenes that makes the system work.

🪄Magic Behind the Curtain: Creation & Redemption

Central to the liquidity of every ETF is the creation and redemption process, a brilliant mechanism that most investors overlook. In contrast to mutual funds, which trade only once daily at NAV, ETFs offer a unique advantage: they trade throughout the day at market prices.

This mechanism allows ETFs to scale liquidity by creating or destroying shares in response to demand.

🏗Creation (Increases Liquidity)

• Triggered by: High investor demand.

• Process: An Authorised Participant (AP) gives a basket of the underlying assets to the ETF issuer.

• Result: The issuer gives new ETF shares to the AP, who adds them to the market. This increases supply and adds liquidity.

🔥Redemption (Maintains Stability)

• Triggered by: Heavy investor selling.

• Process: An AP returns ETF shares to the issuer.

• Result: The issuer gives the AP the underlying assets. The ETF shares are destroyed, tightening supply and helping to maintain price stability.

APs are large financial institutions that provide "two layers of liquidity":

1. Secondary Market: The visible trading of existing ETF shares between investors.

2. Primary Market: The hidden process of creating new shares directly with the issuer.

This dual-layer system means an ETF can trade large volumes efficiently, even if its daily secondary market volume appears low, because APs can create new shares on demand. This is also why ETFs seldom run out of shares.

Market makers are professional traders who provide continuous bid and ask prices for ETFs throughout the trading day. They play an active role in supplying liquidity using advanced algorithms and significant resources.

They profit from the bid-ask spread, especially during market volatility. When buyers pull back, market makers maintain liquidity by hedging their positions with underlying securities or futures contracts. This allows them to keep tight spreads even in difficult conditions.

The effectiveness of an ETF's market makers is more important than its trading volume. An ETF with multiple competing market makers usually has better liquidity than one relying on a single provider, regardless of daily trading figures.

🎢Liquidity in Crisis Mode

All ETFs appear liquid during stable market conditions, but the true test comes when markets experience stress. Do you recall March 2020? During that market crash, ETF trading often remained functional even as certain parts of the underlying markets froze. Three factors proved crucial:

1. 📈 Underlying asset liquidity: ETFs holding highly liquid large-cap stocks generally maintained better spreads than those holding illiquid small-caps or complex derivatives.

2. 🤝AP participation: ETFs with multiple active APs continued to see creation/redemption activity, while those with limited AP involvement struggled.

3. 🏆Market maker diversity: ETFs with several competing market makers maintained better liquidity than those reliant on a single provider.

For ETF UNO readers building resilient portfolios, it's essential to look beyond current liquidity metrics and consider how an ETF might perform during market stress. Ask yourself: "If the market drops 20% tomorrow, will this ETF still trade efficiently?" This mindset sets savvy investors apart.

🌊 Surfing the ETF Liquidity Waves

Today, we explored the hidden dimensions of ETF liquidity that most investors never see:

• ETF liquidity is not just about volume — it comes from both the ETF and its underlying assets

• Implied liquidity is often more important than on-screen numbers

• The creation/redemption mechanism allows ETF liquidity to scale

• Market makers play a huge role in keeping trading smooth

• Liquidity behaves differently in stressed markets — not necessarily worse

To make things easy, here are the Simple habits that help individual investors navigate liquidity confidently:

1. 🌐Check the Underlying Market: An ETF is typically liquid if it holds well-traded assets like the S&P 500, even if its own volume is low.

2. 🏢 Evaluate the ETF Ecosystem: Choose ETFs from large issuers with strong market-making networks for better liquidity support.

3. ⏱️Trade at Smart Times: Avoid the market's first and last 30 minutes to minimise volatility.

4. 🛑Use Limit Orders: Always set a limit price to maintain control over your trade execution.

5. ⚓Stay Calm During Volatility: Expect temporary spread-widening during stress, as ETFs are designed to self-correct.

Liquidity is not only about how easy it is to buy or sell today; it also relates to how well your investments will perform during challenging market conditions. By grasping these advanced concepts, you are laying the groundwork for smarter and more resilient ETF investing.

We hope this edition of ETF101 provides you with an enjoyable reading experience this weekend. Until next time, trade wisely and think deeply. The ETF UNO team is here to guide you.

DISCLAIMER: This article is for informational purposes only and does not constitute investment advice. Always conduct your own research and consider consulting with a financial advisor before making investment decisions.