INSIGHTS

On August 11, 2025

AAM Viewpoints — Dispelling the Myths Surrounding ETF Liquidity

When analyzing an exchange-traded fund’s (ETF) liquidity, many investors use the same measures as they do for stocks and closed-end funds (size, spreads, volumes). This can lead to the assumption that an ETF is “illiquid,” particularly with newer ETFs. However, ETFs are open-ended with two layers of liquidity — the secondary market and the primary market — which are crucial to understanding their true liquidity profiles.

ETF Basics

ETF liquidity is determined by the ability to create or redeem shares. This is a function of the tradability of its underlying assets in the primary market.

The secondary market is where investors buy and sell ETFs on an exchange, similar to stocks. Liquidity here is often judged by measures like trading volumes or bid-ask spreads. However, focusing only on the secondary market can be misleading, especially for ETFs with low trading volumes that may also have highly liquid underliers.

The primary market is where ETF shares are created or redeemed by authorized participants (APs). APs are large institutions who effectively act as a capital markets facilitator and issue new shares (or redeem existing shares) based on the secondary market demand. This makes an ETF’s liquidity tied to how easy it is for these APs to create/redeem shares by purchasing/selling the securities in the ETF’s portfolio. The higher the liquidity of the underlying securities (implied liquidity), the lower the expected trading costs for the end investor in the ETF. To summarize, trading volume is “what traded” and is not “what can be traded.”

Having the primary market as a liquidity source is what differs ETF liquidity to that of stocks and closed-end funds. This open-ended structure makes implied liquidity a more precise liquidity metric since APs can create new shares to meet investor demand.

Source: AAM | For illustrative purposes only.

Here’s Another Way to Think About It…

It is fall, and you decide to operate a fruit stand selling apples. You start off with 10 bags of apples on the stand. Luckily for you, the word gets out quickly that you have the best apples in town. When your fruit stand opens, 11 customers are already in line. Each of the first 10 customers buys one bag of apples.

The 11th customer, along with everybody driving by, may assume that because there are no more bags of apples on the stand, you do not have any additional apples available. That would make sense, right? Wrong.

Luckily, for the 11th customer, and everyone else interested in purchasing your apples, you have a 500-acre apple orchard behind your house and an abundance of apples! In fact, before you blink, there are 10 more bags of apples on the stand! And 10 more, and 10 more!

In this example, the initial 10 bags of sold apples represent your “trading volume” (i.e., ADV), but as you can see, it is not a reliable indication of how many apples are available (overall liquidity). This same premise can be applied to ETFs whose liquidity is determined by the availability and tradability of its underlying portfolio.

ETF Authorized Participants are “At the Ready”

For investors seeking to trade in an ETF with low secondary market liquidity, executing a trade with the assistance of their custodian’s block trading desk may be more efficient than purchasing large volumes directly in the secondary market. Given the liquidity of U.S.-based equities, this approach may be straightforward for both the broker and ETF market makers. For those buying or selling an ETF in the open market at smaller volume levels, setting limit orders is advised to manage potential price fluctuations effectively.

CRN: 2025-0801-12764 R

Shares of any ETF are bought and sold at market price (not NAV) and may trade at a discount or premium to NAV. Shares are not individually redeemable from the Fund and may only be acquired or redeemed from the fund in creation units. Brokerage commissions will reduce returns. 

AAM ETFs are distributed by Quasar Distributors, LLC.