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To maximize the benefits of the ETF wrapper, it is vital to appreciate how, when, and with whom to trade ETFs. We dispel common myths and explain how a deeper understanding of the ETF ecosystem can assist clients in achieving best execution
Assets under management and the average daily volume of an ETF do not necessarily determine its liquidity.ETF liquidity depends on the ability of market makers to hedge their exposure to underlying securities.Investor outcomes in the ETF market depend on how trades are executed, the timing of these trades, and the counterparties involved. Exchange-traded funds (ETFs) offer a wide range of advantages to investors, including intraday liquidity (ability to trade immediately with the current price as your benchmark), holdings transparency (the full holdings are published daily) and certainty of execution (there is no swing price when trading ETFs).
But some investors risk missing out on these benefits due to concerns about the potential liquidity of ETFs. There can also be an element of confusion when it comes to choosing the most suitable ETF trading strategy. Below, we look at four of the most prevalent ETF misconceptions.
Misconception 1: The AUM and trading volumes of an ETF determine its liquidity
While it may be reasonable to conclude that an ETF with a relatively high level of assets under management (AUM) is a more popular or well-established fund, it does not necessarily follow that it must be easier to trade – or that ETFs with lower AUM figures will be more difficult to buy and sell.
When trading an ETF, the counterpart is either another investor or a market maker (unlike a mutual fund where it is the Asset Manager). Market makers are the global investment banks and independent proprietary financial technology companies. Most of the time, the market maker prefers to remain delta neutral and will hedge the ETF to avoid being long or short the exposure. They may hedge with a combination of derivatives, the underlying constituents, other ETFs, etc. The liquidity and spread of the market maker’s ETF quotes are therefore driven by the liquidity of their hedge, not the historical AUM of the fund or its recent trading volumes (see Misconception 2, below).
Take, for example, an ETF that tracks the S&P 500 Index and assume it has very low historical turnover and small AUM. It could be described as having minimal explicit liquidity. However, because it would be straightforward for a market maker to hedge its exposure to this ETF using S&P 500 futures (the most liquid equity futures in the world), its implied liquidity would be extremely high. The same would be true of an ETF that tracked US Treasuries, or other highly liquid asset classes.
Misconception 2: Daily trading values reflect an ETF’s liquidity
Similarly, if the average daily volume (ADV) of an ETF on exchange trades appears low, investors may be tempted to believe that they would have problems buying and selling the ETF in the future. There are two reasons why they would be mistaken. Firstly, as described above, historical trading volumes have little bearing on the ability of market makers to hedge their exposure to the underlying securities in an ETF – and this is the factor that is most important in determining the liquidity of an ETF.
Secondly, publicly available ADV figures only represent the ADV of the listing being analysed. According to ETFBook, the proportion of total UCITS ETF trading carried out on primary stock exchanges declined from 29.5% in 2020 to 22.0% in 2024. Over 50% of ETF trades by notional is now conducted on Multi-Lateral Trading Facilities (MTF) like Bloomberg RFQE or Tradeweb using the request-for-quote (RFQ) protocol. 25% is traded over the counter (OTC) transactions via the Systematic Internaliser regime.
Finally, listing fragmentation is a point to consider as many ETFs are listed on multiple exchanges in different currencies. As such, using on-exchange ADV figures can only provide a very limited representation of total trading activity and is not a reliable way of assessing ETF liquidity.
Misconception 3: ETF liquidity can be measured by the on-exchange spread
Narrow bid-ask spreads on any given security are seen as a sign of high liquidity, while wider spreads suggest that trading may be riskier or more difficult. However, as is the case with published ADVs (see Misconception 2, above), the on-exchange bid-ask spread for a particular ETF offers an incomplete picture of potential liquidity. The on-exchange spread only reflects the buying and selling costs for investors who want to trade on risk, like a regular stock, with the price locked in at the time of trade, on the primary stock exchange.
Although one of the major benefits of ETFs is intraday liquidity, many clients choose to trade versus NAV as they do not possess an intraday delta view. The NAV spread may be smaller than the on-exchange spread as the market maker does not need to charge a delta hedge risk premium when trading versus NAV. Second, most ETF trading does not take place on the primary stock exchange but rather off exchange. Most authorized participants do not provide on-exchange quotes due to the lower levels of transaction flow observed on those venues. Competition in the dealing process helps achieve best execution and often this is attained using the RFQ protocol on MTF or OTC. This means that on-exchange spreads may create a misleading or partial impression of ETF liquidity.
Misconception 4: An investor’s ETF execution strategy is not important
The way in which investors choose to trade their ETFs can have a significant impact on costs and risk. Unlike mutual funds, where trades are only processed once a day versus NAV, ETF investors have much greater control over execution: they can decide when, with whom and at what venue to trade, giving them the potential to meet their policy of best execution.
The size of the bid-ask spread quoted by market makers will depend on factors such as:
Trading on risk means investors are able to lock in a purchase or sale price for an ETF, although the spread for risk trading might be wider than NAV due to the delta hedge risk premium. These are the costs incurred by the market maker in hedging ETF the transaction. However, investors in ETFs may be able to benefit from the concept of netting, where buyers and sellers match off. This can reduce the need for a primary market trade and lead to lower bid-ask spreads in the secondary market either on risk or versus NAV. In exposures where the potential creation-redemption spread is large as a result of financial transaction taxes (France for instance) and stamp duties (UK for example), the advantages of netting can be even greater.
Investors should also take into account the current status of the primary market where an ETF’s underlying securities are traded: if the market is no longer open, this can have an impact on bid-ask spreads. The flexible nature of ETFs means that they can be traded around the clock, on the secondary market, provided the relevant venue is open and dealers are providing quotes. But for on-risk trading, bid-ask spreads may be higher if it is more difficult for market makers to hedge their transactions – as might be the case when underlying markets are closed.
Take, for example, a client who is looking to trade an ETF based on the MSCI World Index. As the trading day progresses, the proportion of the underlying markets open in the index increases, and market makers can have a greater level of confidence in their iNAV calculations – resulting in lower bid-ask spreads. It is important for investors to understand that the hedge for any given ETF can be dynamic and is liable to change throughout the day, with a knock-on effect on risk spreads.
Similarly, timing can be important when carrying out ETF trades versus NAV. Using the same example of an MSCI World Index ETF, if a NAV trade in such a fund were locked in at 8am UK time on a Thursday, say, roughly 78% of the ETF price would not be determined until 9pm UK time on the Friday evening when the US and Canadian stock market closes. This would present the investor with a significant level of delta risk.
Ultimately, ETF liquidity depends not on factors such as historical trading volumes and AUM, but on the ability of market makers to hedge their exposure to underlying securities. Investor outcomes in the ETF sphere are dependent on how trades are carried out as well as their timing and the counterparties involved in each transaction.