Mastering ETF Liquidity: The Key to Building Efficient Model Portfolios

However, the benefits of an ETF in a model can vanish if one key factor isn’t considered. And that’s liquidity.

Thanks to their structure, ETFs provide some unique liquidity aspects, both in the secondary and tertiary marketplaces. But it’s key to building portfolios and models so that investors understand how these types of liquidity work for them or their clients. Choosing correctly can limit costs and prevent some nasty side effects.

ETFs are a remarkable investment vehicle, particularly when compared to classic fund types like mutual funds or closed-end funds (CEFs). That’s because of ETFs’ underlying structures and how they are created and traded.

Unlike a mutual fund or CEF—which gathers cash directly from investors and purchases underlying securities—ETFs are created in a special way. This has been dubbed the creation and redemption process. Here, authorized participants (APs)–—who are registered, self-clearing broker-dealers—assemble the underlying securities of the fund in appropriate weightings. These baskets are called creation units, typically 50,000 ETF shares. The AP then delivers those securities to the ETF sponsor, who then bundles the securities into the ETF and hands them back to the AP. The authorized participant then places them on the secondary market.

This secondary market is where the vast bulk of us play. When you want to purchase or sell an ETF, it’s done on a major exchange. You click ‘buy’”, the cost is deducted from your brokerage account, and the shares are transferred to you just like you would buy a share of Walmart or Microsoft.

If there is more demand for the ETF, APs can create more units. If there is less, they can reverse the process. This reversal is one of the ways that ETFs allow investors in the secondary market to avoid capital gains taxes on what goes within the fund, unlike a mutual fund.

This primary market liquidity enhances the secondary market liquidity and provides an overall more liquid fund experience for investors.

For the most part, these primary and secondary marketplaces for ETF shares work well. But it doesn’t always. That comes down to bid-ask spreads and trading volumes on the secondary market.

Remember, the vast bulk of us—including many large institutional investors—buy/sell ETFs here. This can prove to be problematic and incur larger costs for investors. This is due to market-makers and the underlying liquidity of what’s inside the ETF in the first place.

Market-makers’ job is to facilitate trading and try to keep prices as close to the ETF’s net asset value as possible. But sometimes, this is not the case. Illiquid securities, bonds, international stocks, etc. can cause havoc on a market-maker’s ability to provide correct liquidity pricing of an ETF. This can result in investors paying more for or receiving less when they buy or sell shares of an ETF in the secondary market.

And this isn’t just comparing ETFs with high trading volumes and those with low trading volumes. This chart looks at the three biggest S&P 500 ETFs on the planet: the SPDR S&P 500 ETF Trust, iShares Core S&P 500 ETF, and Vanguard S&P 500 ETF. Using trade tool Virtu and placing a $25 million Volume-Weighted Average Price (VWAP) block trade over 30 minutes, you can see the differences in total costs for the three massive ETFs. ¹

Source: State Street

Virtu also found that in times of volatility and rising VIX regimes, bid-ask spreads get wider across various ETFs, providing for higher overall total costs.

So how does this play out for advisors and those looking to use ETFs in their model portfolios? The answer is that liquidity matters. The key is that _

The trick is gauging assets under management size or volume of expected business/model.

With larger model portfolios, using the primary and secondary marketplaces to your advantage can help reduce costs. Most brokerages can execute block trades, using all the liquidity channels for an ETF. This can also include directly interacting with APs. Smaller, less traded secondary market funds can also benefit from this tier of liquidity. For a large model, the world is your oyster. Total cost of ownership should be considered and an ETF’s total liquidity should be a factor.

For smaller models, the answer gets a bit trickier. Here, investors may not be able to tap the primary market at all nor have the full range of block trades/tools that are available. Trading volumes and bid-ask spreads need to be considered as the primary liquidity factor. Longer holding periods tend to erase bid-ask costs as well. Limit orders need to be used to keep variation in share price low.

These funds were selected based on their assets under management and trading volumes, providing secondary market liquidity. They are sorted by their YTD total return, which ranges from 5.3% to 25%. They have expenses of 0.03% to 0.40%. They have assets under management between $62B and $1.55T. They are currently yielding between % and %.

In the end, liquidity is a major factor that investors need to consider when building a model portfolio. ETFs can provide that liquidity on the primary and secondary markets. The key is understanding just how big your assets are and your ability to tap into both liquidity streams. Total cost of ownership with regard to bid-ask spreads must be considered when looking at what ETFs to choose for your model. Either way, liquidity matters, especially when the markets get dicey. ETFs can make that liquidity easier to come by.

Investors often overlook liquidity when building their model portfolios. But this factor is a major sticking point. Poor liquidity can increase costs and ultimately reduce returns. Luckily, ETFs can provide two layers of liquidity for portfolios. Understanding how they work and how you can tap them should be considered when selecting funds for a model.

¹ State Street (August 2024). Liquidity: Flexibility to Navigate Any Market