The ETF market is actually made up of two markets - a primary market where ETF shares are created and redeemed, and a secondary market where ETF shares trade on an exchange.
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:
The key to ETF liquidity lies in ETFs' open-ended structure. Unlike single stocks, which 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.
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. For large trades of Vanguard ETFs, we recommend clients contact our Capital Markets Team, which operates as a conduit between market makers and our clients to help facilitate the best possible trade execution.
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.
ETFs allow you to place any type of trade that you would with stocks. Here are some common order types:
You buy or sell immediately at the best available current price. When you place a market order, your priority is making the trade quickly, not securing a particular price.
You set a price and execute your trade only if shares are available at that price or better. Limit orders protect you from executing a trade at an undesirable price. This type of order will typically not be accepted if the market considers the limit price to be too far away from the prevailing market price of that stock. Limit orders can be amended or cancelled only when the market is closed, provided the order has not already been executed. When you place a limit order, your priority is securing a certain price, not speed of execution.
You set a price – the stop price – at which you automatically buy or sell. When the ETF hits the stop price, your stop order becomes a market order. The price you then get is the best available current price. That price may have changed, for better or worse, in the moments after your stop price triggered your market order. When you place a stop order, your priority is trying to limit a loss or protect a profit.
A conditional order is made when you set a "trigger price" and a "limit price". When the share price rises or falls to your trigger price, the broker endeavours to place a limit order into the market on your behalf. There is no guarantee that the trade will be executed when the trigger is hit as the order will need to satisfy trading rules.
A broking house, if one is available to you, can use its trading tools and network of relationships to help you when you place a large order. Your broker may be able to:
A Vanguard sales representative is also a good starting point for a discussion about ETF liquidity. He or she can consult with a capital markets specialist on your behalf, or refer you directly. The specialist can access additional data on the depth of liquidity and suggest a trading execution strategy.
For larger trades, the specialist can consult with market makers to help you maximise potential liquidity in the ETF. Your capital markets specialist will know whether your requested trade size is large enough to engage a market maker or whether liquidity is naturally available for your order. A large order for one product may not be a large order for another.
The ASX (www.asx.com.auopens new window ) has a useful broker search engine to assist you in selecting the broker which best suits your investment trading needs.
A number of factors can influence how you place ETF orders and when you should call a broker for assistance.
Here are two common scenarios, along with some practical tips that will help you place ETF orders quickly and confidently.
You want to execute your trade right away
Whether you want to lock in a current market price, avoid adverse market movements or simply execute your daily trades and move on to other priorities, the key to determining your trading approach is understanding the effect of trading volume.
If the ETF you want to trade has a high average daily volume (ADV) you can execute a simple limit order through your trading site. However, when you want to place an order for an ETF with a low ADV, it may be better to call the Vanguard Capital Markets Team to coordinate the trade with your broker and the market maker. Keep in mind that your broker has access to an extensive network of liquidity providers that can help place your order and execute your trade, especially in low-volume situations.
You want to work an order over time
When your objective is to place an order for the best possible average trade price over a period of time and the ETF in question is trading at a high ADV, your best option is to have the broker work the ETF order.
When your objective is the same, but the ETF is trading at a low ADV, your broker can assist with more sophisticated order and execution strategies, including:
TWAP and VWAP orders ensure your trade will be executed not at the lowest or the highest price but at an average of the two during the specified period of time.
By following a few best practices, you can help ensure favourable prices for your ETF trades.
Limit orders let you determine the maximum or minimum price at which you’ll execute an ETF trade. While limit orders offer you control over price, there is always some risk that your order won't be fully executed.
Market orders can be effective when you’re buying or selling ETFs with significant liquidity and narrow spreads. However, since the overriding objective of a market order is trade execution rather than price protection, it’s possible you will receive an undesirable price for your trade.
Be wary during volatile periods or when there are major events that affect markets. Market volatility can cause the prices of an ETF's underlying securities to move sharply, which can in turn cause the ETF's shares to have wider bid-ask spreads or larger premiums or discounts. Limit orders may be beneficial in such situations because of the price protection they provide.
Investors should pay attention to market news as ETF prices may swing in response to the release of economic indicators or statements from central banks, as well as earnings and other news from companies that are large constituents of an ETF.
A common misconception is that ETFs with lower average daily volume (ADV) are not as liquid as others in the marketplace. ADV is generally a good gauge of liquidity for a single stock because the number of its outstanding shares is generally fixed. However, ETF shares can be created or redeemed through an authorised participant, so the liquidity of the ETF's underlying securities is what matters most. When the underlying securities are difficult to trade, it can result in a wider bid-ask spread for the ETF. Learn more.
Spreads can widen at certain times each day or on certain days of the year.