ETFs & Funds · Intermediate · 4 min

Liquidity and spreads in ETFs

You can explain where an ETF's liquidity really comes from, why spreads widen when the underlying market is closed, and how to trade ETFs at fair prices.

Volume isn't everything

Beginners often judge how easy an ETF is to trade by its daily volume. A fund that trades only a few thousand shares a day looks risky, a heavily traded one looks safe.

That rule works for shares, but not for ETFs. An ETF with little volume can be cheap to trade, and a very popular one can be surprisingly expensive at the wrong time of day. The reason lies in how ETF prices are made.

Liquid like its holdings

Most trading in ETFs runs through market makers, who quote bid and ask prices all day. They base those prices on the value of the fund's holdings, and they can create or redeem ETF shares through authorized participants, as you saw earlier in this rubric.

That has a consequence: an ETF is roughly as liquid as the securities it holds. An ETF on large, heavily traded shares can be bought in size at a tight spread, even if the ETF itself has little volume. An ETF on small companies, emerging market bonds or other thinly traded assets will have wider spreads, however popular it is.

Timing matters too.

A European-listed ETF on US shares trades on Xetra from 9:00, but its holdings start trading in New York only at 15:30 Central European winter time. Before that, market makers have to estimate the holdings' value from futures and other signals, and they protect themselves with wider spreads.

To judge a fair price, many exchanges publish an indicative NAV, or iNAV: an estimate of the fund's value per share, recalculated throughout the day from current prices. If the ETF's bid and ask sit far from the iNAV, something is unusual.

The SEC also warns that in stressed markets, ETF prices can move away from the value of their holdings. A limit order protects you from paying more than you intended.

Morning 0.15%, afternoon 0.04%

A fictional investor in Europe buys an ETF on large US companies for 5,000.

At 9:15, New York is closed. The spread is 0.15%, about 7.50 on the purchase.
At 16:00, with New York open, the spread is 0.04%, about 2.00.

Same fund, same day, almost four times the cost. With a limit order at a price near the iNAV, the investor would also be protected if the price jumped while the order was being placed.

Common mistakes

Judging liquidity by ETF volume. Look at what the fund holds.
Trading when the underlying market is closed. Spreads are usually wider then.
Using market orders in ETFs. A limit order near the iNAV avoids surprises.
Trading at the open or close. The first and last minutes often have the widest spreads.

The takeaway

An ETF is as liquid as what it holds, not as its own trading volume. Trade when the underlying market is open and use limit orders.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the session in which the ETF's US holdings are trading.

Tap the chart.

Only from 15:30 CET are the US shares trading. Before that, market makers must estimate their value, and spreads are often wider.
2An ETF trades only a few thousand shares a day, but holds large, liquid stocks. Is it hard to trade?

An ETF's real liquidity comes from its holdings, thanks to creation and redemption.
3What is the indicative NAV of an ETF?

The iNAV is calculated from current prices of the holdings and helps judge whether the ETF's price is fair.
4Which order type helps avoid paying a wide spread in an ETF?

A limit order sets the worst price you accept, as covered in the lesson on limit orders.

of 4 correct.