Understanding Liquidity: Beyond Average Daily Volume
Why trading volume is a poor proxy for an ETF's true liquidity.
A common misconception among novice investors is judging an ETF's liquidity solely by its Average Daily Volume (ADV) on the exchange. This metric, while relevant for small trades, fails to capture the true liquidity of an ETF.
The "Implied Liquidity" of the Underlying Basket
An ETF's true liquidity is derived from the liquidity of the securities it holds. This is known as "implied liquidity." Because APs can create new shares on demand, an ETF with zero trading volume can still be highly liquid if it holds liquid assets like Apple or Microsoft stock. An institutional investor can place a massive buy order, and the AP will simply buy the underlying stocks and create the necessary ETF shares to fill the order.
Bid/Ask Spreads and Transaction Costs
The bid/ask spread of an ETF is a function of the liquidity of the underlying basket and the risk the market maker takes in holding that inventory. For ETFs holding liquid US equities, spreads are typically penny-wide. For ETFs holding illiquid assets (e.g., municipal bonds or international small caps), spreads will be wider to compensate the AP for the difficulty and cost of trading the underlying securities and for the risk of price movement during the creation/redemption process.
Intraday Indicative Value (IIV) vs. Net Asset Value (NAV)
Unlike mutual funds, which strike a single NAV at the end of the day, ETFs have a theoretical fair value that fluctuates second-by-second. This is tracked by the Intraday Indicative Value (IIV), also known as the IOPV (Indicative Optimized Portfolio Value).
The Stale Price Problem in International Funds
IIV is calculated by taking the last traded price of the underlying securities. This works well for US equity ETFs. However, for international ETFs, this metric is often flawed. If a London-based ETF is trading in New York at 2:00 PM EST, the London market is closed. The IIV is calculated using the "stale" closing prices of the British stocks. Meanwhile, news may have broken that affects the value of those stocks. Consequently, the ETF price in New York may deviate significantly from the IIV, not because of inefficiency, but because the ETF price is discovering the new fair value before the London market reopens.
The Premium/Discount Puzzle
An ETF trades at a premium when its market price is higher than its NAV, and at a discount when it is lower. While arbitrage usually keeps these deviations small, they can persist in certain environments.
Why Deviations Occur
Deviations occur when the cost or risk of arbitrage exceeds the potential profit. For example, in a rapidly falling market, APs may be reluctant to buy illiquid bonds to create ETF shares because they fear the bonds will lose value before they can deliver them to the issuer. This hesitation reduces the buying pressure needed to close a discount. Additionally, in markets with capital controls or trading holidays (like China or Egypt), APs cannot access the underlying shares to create or redeem, leading to "dislocated" pricing where the ETF trades purely on sentiment.
Persistent Discounts in Closed-End Funds vs. ETFs
Unlike Closed-End Funds (CEFs), which have a fixed number of shares and can trade at massive double-digit discounts for years, ETFs have an open-ended structure. The ability to create and redeem shares ensures that discounts in ETFs are generally fleeting and arbitrage-driven, whereas CEF discounts are structural and sentiment-driven. A CEF discount represents a lack of demand for the manager's strategy; an ETF discount represents a temporary friction in the arbitrage mechanism.