An exchange-traded fund (ETF) is a unique type of investment vehicle that combines the diversification benefits of a mutual fund with the intraday trading flexibility of a stock. While these aspects of ETFs are generally well known, the liquidity of ETFs is frequently misunderstood. Trading volume, for example, is mistakenly thought of as the only indicator of ETF liquidity, but this “on-screen” activity is usually only the tip of the liquidity iceberg.
The multiple layers of ETF liquidity
The unique structure of ETFs has led to the creation of three layers of liquidity: on-screen liquidity, dealer inventory, and the liquidity of the underlying basket of securities. While technological innovations allow individuals to tap the first layer from virtually any computer or mobile device, the deeper layers of liquidity are easily taken advantage of through a broker-assisted trade.
Best practices for ETF trading
Although ETFs commonly cost less than their active mutual fund counterparts, investors must pay a commission on each trade. In addition, their low-cost structure is built in part on well-executed trading. For that reason, it can matter whether investors choose to trade on-screen, using the topmost layer of ETF liquidity, or make broker-assisted trades, through which they may access the deeper and most cost-effective layers of ETF liquidity.
To help ensure best-execution results, investors should ask two questions to decide whether to execute a trade independently or with broker assistance: Is the trade small or large? Is the trade urgent?
1 The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index.
2 A held order must be promptly executed so that the request is immediately filled. Due to the urgent nature of the transaction, traders generally have little discretion when finding a price and may be forced to match the highest bid or offer the lowest selling price. Held orders are used by investors who want to quickly change their exposure to a certain stock or group of stocks.