Understanding underlying liquidity: How in kind transfers contribute to ETFs' tradability

Share volume isn't the whole story when it comes to ETFs

Key Insights

  • ETFs may remain liquid even when their own shares are thinly traded.
  • While individual investors trade ETF shares on an exchange (like a stock), large institutional trading desks can create and redeem ETF shares through in kind transactions.
  • In kind transactions play a central role in ensuring that supply and demand for ETF shares remain in balance.
  • To determine how liquid an ETF is, knowing how often the ETFs' own shares are traded on the exchange is less important than understanding the liquidity of the funds' underlying holdings.

Active ETFs have boomed in recent years. Since a shift in SEC rules made it easier for investment firms to manage the format in 2019, both established managers and new entrants have taken the plunge into the sector. Now that many active ETFs have built up a three-plus year track record, investor interest has surged: Active ETFs comprise just 7% of total ETF assets, but have accounted for greater than 30% of the flows year-to-date, and now account for almost $600 billion in total assets1.

Key to the funds' appeal is their capacity to offer a combination of the features of both active funds (such as the possibility of outperforming the benchmark) along with those of ETFs (including generally lower fees, greater potential tax efficiency and intra-day liquidity). As new funds continue to emerge, investors may well wonder whether they can expect the same liquidity in active ETFs that they're used to from passive index ETFs. The answer is yes—but understanding why requires looking under the hood of ETFs and examining how they create and redeem shares.

Primary markets vs. secondary markets

To understand ETF liquidity, it's necessary to understand the distinction between primary and secondary markets.

Traditional mutual fund shares are purchased directly from the fund company. ETF shares are purchased on an exchange, just like buying or selling a stock.

When shares are purchased directly from their originator, that's a primary market transaction. When shares are purchased on a public exchange, that's a secondary market transaction. While ordinary investors can only obtain ETF shares on the secondary market, primary market transactions do occur. In fact, they're the reason ETFs are generally more tax-efficient than their mutual fund counterparts.

Throughout the trading day, if there are substantially more investors buying than selling an ETF's shares, new shares may need to be created by certain large institutional trading desks known as authorized participants. These authorized participants create new shares by engaging in in kind transactions, buying shares of the underlying holdings in the ETF and delivering them to the fund company in exchange for new ETF shares. The trading desk can then turn around and sell the freshly-minted, in-demand ETF shares on the secondary market.

If there are more sellers than buyers for an ETF, the process happens in reverse: An authorized participant can redeem ETF shares, returning them to the issuer in exchange for the underlying holdings. This process is known as an in kind transfer. Whenever new shares are created to meet excess demand or redeemed to eliminate excess supply, no cash changes hands in the trade, which means no capital gains are generated inside the fund. This process helps to reduce taxable capital gains within ETFs (including active ETFs), to the potential benefit of taxable investors.

How in kind redemptions help boost liquidity

In addition to possible tax benefits, the creation and redemption of shares via in-kind transactions helps ensure that the value of an ETF's shares generally moves in connection with the value of its underlying holdings.

If changes in the demand for an ETF result in the market price of its shares diverging slightly from the value of an equivalent basket of its holdings, traders at the authorized participants will use the in-kind process to quickly bring it back in line. Most ETFs have dozens of authorized participants tracking their share price throughout the trading day, with a deviation of only a few basis points enough to trigger an in-kind exchange.

It also means that when determining how liquid an ETF is, analysts don't simply examine how often the ETF's own shares are traded on the secondary market. They also examine the liquidity of the fund's underlying holdings, how easy it is for authorized participants to create and redeem shares. The determinants of underlying liquidity include the size of the required creation basket, whether the securities the ETFs hold trade during U.S. market hours, any creation fee charged to authorized participants, and how liquid the underlying securities are themselves.

ETF Trading Process Secondary Market Exchange (Lit) Primary Market OTC (Dark) Buyer/Selller Brokerage ETF Issuer Authorized Participant/ Market Maker

The significance of underlying liquidity

ETFs are generally at least as liquid as the basket of securities they hold. If the underlying holdings are highly liquid—for example, a fund which holds large cap U.S. equities—an investor will be able to easily exit or enter the fund at a desired price, regardless of how much volume the ETF itself might be trading each day.

A variety of different metrics exists that can help investors assess the underlying liquidity of a fund.
These include:

- INAV, indicative net asset value, a measure of net asset value of the underlying securities held within the ETF, translated into the ETF price. INAV is published throughout the date by the exchange.

- Implied liquidity, an estimate of the trading volume of the underlying securities in the ETF compared against the size of the share creation basket

- % Off-Exchange, a measure of the percentage of the ETFs shares being traded in large blocks by market makers

As active ETFs are a relatively new asset class, trading volume in many active ETFs remains lower than in that of older index products. Generally, investors in all types of active funds tend to have longer holding periods, and we anticipate that many active ETFs will tend to demonstrate lower trading volume than their index counterparts. But the fact that there's a market maker ready and waiting to stand on the other side of the trade means that active ETF shares will continue to trade freely.

RELATED INSIGHTS
RELATED PRODUCTS AND SOLUTIONS
  • 1. Here's Why Active ETFs Are So Hot Right Now | Morningstar
  • 2. Source: Morningstar, Fidelity, as of January 29, 2024
  • Diversification does not ensure a profit or guarantee against a loss.
  • Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks.
  • In general the bond market is volatile and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation, credit, and default risks for both issuers and counter parties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
  • Semi-Transparent Active Equity ETFs are different from traditional ETFs. Traditional ETFs tell the public what assets they hold each day. These ETFs will not. This may create additional risks for your investment. For example: You may have to pay more money to trade the ETF's shares. These ETFs will provide less information to traders, who tend to charge more for trades when they have less information. The price you pay to buy ETF shares on an exchange may not match the value of the ETF's portfolio. The same is true when you sell shares. These price differences may be greater for these ETFs compared to other ETFs because they provide less information to traders. These additional risks may be even greater in bad or uncertain market conditions. The ETFs will publish on their website each day a "Tracking Basket" designed to help trading in shares of the ETFs. While the Tracking Basket includes some of the ETF's holdings, it is not the ETF's actual portfolio. The differences between these ETFs and other ETFs may also have advantages. By keeping certain information about the ETFs secret, these ETFs may face less risk that other traders can predict or copy their investment strategy. This may improve the ETF's performance. If other traders are able to copy or predict the ETF's investment strategy, however, this may hurt the ETF's performance.
  • Because shares are traded in the secondary market, a broker may charge a commission to execute a transaction in shares, and an investor may incur the cost of the spread between the price at which a dealer will buy shares and the price at which a dealer will sell shares.
  • Additional information for Semi-Transparent Active Equity ETFs: The objective of the actively managed ETF Tracking Basket is to construct a portfolio of stocks and representative index ETFs that tracks the daily performance of an actively managed ETF without exposing current holdings, trading activities, or internal equity research. The Tracking Basket is designed to conceal any nonpublic information about the underlying portfolio and only uses the fund's latest publicly disclosed holdings, representative ETFs, and the publicly known daily performance in its construction. You can gain access to the Tracking Basket and the Tracking Basket Weight overlap on Fidelity.com or i.fidelity.com. Although the Tracking Basket is intended to provide investors with enough information to allow for an effective arbitrage mechanism that will keep the market price of the Fund at or close to the underlying NAV per share of the Fund, there is a risk (which may increase during periods of market disruption or volatility) that market prices will vary significantly from the underlying NAV of the Fund; ETFs trading on the basis of a published Tracking Basket may trade at a wider bid/ask spread than ETFs that publish their portfolios on a daily basis, especially during periods of market disruption or volatility, and therefore may cost investors more to trade, and although the Fund seeks to benefit from keeping its portfolio information secret, market participants may attempt to use the Tracking Basket to identify a fund's trading strategy, which, if successful, could result in such market participants engaging in certain predatory trading practices that may have the potential to harm the Fund and its shareholders. Because shares are traded in the secondary market, a broker may charge a commission to execute a transaction in shares, and an investor may incur the cost of the spread between the price at which a dealer will buy shares and the price at which a dealer will sell shares.
  • ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses.
  • Fidelity Investments® provides investment products through Fidelity Distributors Company LLC; clearing, custody, or other brokerage services through National Financial Services LLC or Fidelity Brokerage Services LLC (Members NYSE, SIPC)
 
 

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