Clearing Up the Misconception: ETF Trade Volume vs. Liquidity

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A client recently expressed interest in the Natixis Loomis Sayles Focused Growth (LSGR) ETF* but had concerns about its low trading volume. In our experience this is the most common, but easily addressed, misconception about ETF liquidity.

Indeed, LSGR has a 30-day average trading volume (ADV) of roughly 100 shares on the secondary market (as of 11/10/2023). This low average trade volume can be common in relatively new ETFs like LSGR, which launched in June 2023. However, an investor could buy up to roughly 30 million shares (over $800 million notional value) at the current market quote or better. How is this possible?

Where’s the Liquidity?
As illustrated below, ETF liquidity is determined by trading volume of all underlying holdings in the portfolio creation basket. Based on LSGR’s holdings and weights (as of 11/10/2023), market makers¹ would be willing to facilitate new buy orders up to 32 million shares at the current National Best Bid/Offer² (NBBO) asking price of $25.85 or lower, depending on trade size. This equates to a notional value of over $820 million. This secondary market trade would likely flow into the primary market as new shares would need to be created to meet this outsized demand.

Source: Bloomberg/Natixis ETF Capital Markets Group. Included for illustrative purposes only.

“Implied liquidity” is a measure of an ETF’s potential trading volume based on its components and liquidity profile. In the example above, FactSet Research Systems Inc. (FDS) would be considered the least liquid basket holding, per its ADV. The least liquid ETF holding typically determines how much of the ETF could be bought or sold on a given day without causing undue friction³ in the underlying security prices. Remember, when ETF units are created or redeemed in a standard in-kind primary market order, the full basket of underlying holdings will be included in the transaction.

Executing an ETF Trade
In our example a very large buy could be fully executed at the market quote of $25.85 or lower (even if only 100 shares are being offered at the NBBO on-screen). Economies of scale play a key role as liquidity providers’ fixed costs to create/redeem ETF shares become a smaller percentage of the overall transaction for large trades. Typically, the best possible execution price on these large purchases is the intraday net asset value (iNAV)⁴, as liquidity providers would ideally avoid selling shares for less than the underlying components’ actual worth.

To optimize trade execution, we suggest using limit orders⁵ instead of market orders for on-screen trading. For large lot trades (over roughly 2,000 shares), financial advisors can consult with an ETF issuer’s capital markets team for advice on best practice or contact their dedicated broker/dealer ETF block trading desk to facilitate the order.

Let’s test our theory by considering two real world Natixis ETF transactions.

ETF Example 1: A Large Lot Purchase
A large block purchase of 199,000 shares of LSGR was executed on the launch date (6/29/2023) at a share price of $25.04 for a total value of $4.98 million. As it was the first trading day, there was minimal secondary market volume and limited shareholders. However, since ETF shares can be created on demand, the order was executed at a price 1 cent above the iNAV ($25.03) and 3 cents below the NBBO ask ($25.07) at the time of the trade. This amounts to cost savings of $5,970 for executing a large block order versus trading at on-screen levels.


Source: Bloomberg/Natixis ETF Capital Markets Group

ETF Example 2: A Large Lot Sale
Would the trading execution on ETFs of similar size and average trade volume be equally efficient for a sell order? The answer is yes. For example, on 9/1/2023, a large Natixis Vaughan Nelson Mid Cap ETF (VNMC) block sale of 136,000 shares was executed at $29.88 for a total value of $4.06 million. At the time, the 30-day ADV for VNMC was only about 1,000 shares. Once again, given that ETF shares can be redeemed directly by a liquidity provider, this order was executed at 1 cent below the iNAV and 3 cents above the NBBO bid at the time of the trade. This amounts to cost savings of $4,080 for executing a large block order as opposed to trading at on-screen levels.


Source: Bloomberg/Natixis ETF Capital Markets Group

ETF: Demand, Not Supply
In summary, the ETF secondary market activity can be viewed as the demand for a product – but not the supply – because ETF shares can be continuously created from the underlying portfolio by market makers. This is unlike a normal stock with a finite number of shares outstanding. Therefore, in contrast to single stocks, investors should not view the average daily trading volume as a barometer for how much liquidity an ETF actually has.

When placing a trade, investors have a wide range of tools and resources at their disposal to enhance best execution, including contacting the ETF issuer’s Capital Markets Desk and the broker/dealer’s ETF block trading desk.