Liquidity in ETFs

One of the primary advantages of ETFs is that there are two sources of liquidity. There is liquidity on the market as defined by the securities on issue and the depth of trading on-market. There is also liquidity that sits with the issuer and the ability to create or redeem ETF securities to meet investor demand – this liquidity reflects the open-ended nature of ETFs and the liquidity of the securities held by the ETF.

Where is liquidity found?

ETFs are open ended: for example, if liquidity in the market was $5 million and an investor wanted to purchase $10 million of Vanguard ETF units, they could contact an Authorised Participant (AP), who has the option to create a further $5 million worth of ETF units with Vanguard and then sell directly to the investor. The securities required to deliver in the creation process are readily available (for example ASX / S&P 300 securities) which supports the liquidity of the products to meet demands from buyers and sellers. Conversely, if an investor wanted to sell $10 million worth of Vanguard ETF units, the AP would provide a purchase price for the securities with the investor then redeem the $10 million worth of ETF units with Vanguard. It is the ability to create and redeem ETF units with the issuer that makes ETF’s such an innovative and flexible investment vehicle.

How can an ETF’s liquidity be measured?

A good measure of ETF liquidity is the liquidity of the underlying stocks in the index the ETF tracks. Unlike shares, an ETF’s liquidity should not be determined by trading volume, even a relatively small ETF will be liquid if there is good liquidity in the securities that make up the ETF units.

What motivates APs and market makers to maintain liquidity?

AP’s operate at arms-length from ETF issuers. They are remunerated by their own market activities. Market makers in Australia are offered an incentive to maintain spreads and liquidity on market via a financial incentive offered by the ASX. APs and market makers are active market participants and earn revenue through the bid/ask spread and volumes that they trade. AP’s earn revenue by acquiring ETF’s in the primary market at the ETF’s NAV and then selling in the secondary market at a margin above the NAV. Similarly they can acquire ETF securities in the secondary market below the NAV and redeem in the primary market. Competition between the APs quoting each ETF security helps to ensure that bid/ask quotes for the ETF securities are consistent with the NAV. APs that quote wide spreads will be undercut by other APs and as a result will not have competitive trades available for the market.

How does Vanguard select market makers?

In selecting market makers for Vanguard ETF’s, Vanguard focuses on companies trading ETF’s in Australian and international financial markets. The companies selected by Vanguard currently operate as market makers in existing Australian ETF securities quoted on the ASX and have agreements with the ASX to operate in this capacity. Internationally, the market makers selected will also have experience in the respective ETF markets, such as the New York Stock Exchange.