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.


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