How ETFs Impact Underlying Stock Liquidity
The ETF-Stock Liquidity Connection
Exchange-traded funds now hold approximately $8.5 trillion in US equity assets as of late 2024. The three largest S&P 500 ETFs alone (SPY, IVV, VOO) collectively manage over $1.5 trillion. When ETF trading occurs, underlying stocks experience direct volume effects through the creation and redemption mechanism.
This relationship flows in both directions. ETF liquidity depends partly on underlying stock liquidity, and underlying stock trading volume increasingly originates from ETF-related activity. For small-cap stocks held in multiple ETFs, the ETF ownership share can exceed 15-20% of free float, making ETF flows a significant driver of daily volume.
How ETF Creation and Redemption Works
ETFs maintain price alignment with their underlying holdings through authorized participants (APs), typically large broker-dealers with the operational capacity to transact in baskets of securities.
Creation process:
- An AP observes that ETF shares trade at a premium to net asset value (NAV)
- The AP purchases the underlying basket of stocks in the open market
- The AP delivers this basket to the ETF sponsor
- The ETF sponsor issues new ETF shares to the AP
- The AP sells these new ETF shares in the market, capturing the premium
Redemption process:
- An AP observes that ETF shares trade at a discount to NAV
- The AP purchases ETF shares in the open market
- The AP delivers these shares to the ETF sponsor
- The ETF sponsor delivers the underlying basket of stocks
- The AP sells these stocks, capturing the discount
Standard creation unit size: 25,000 to 100,000 ETF shares per creation basket, depending on the fund. For SPY, one creation unit equals 50,000 shares, representing approximately $28 million in market value (at $560 per share).
Impact on Underlying Stock Volume
When creation or redemption occurs, the underlying stocks experience direct trading volume. This volume impact varies by stock size within the index.
Example: S&P 500 ETF creation of $100 million
The AP must purchase a proportional basket of all 500 stocks. Approximate allocation:
- Apple (7.2% weight): $7.2 million purchase
- Microsoft (6.8% weight): $6.8 million purchase
- Small-cap component (0.01% weight): $10,000 purchase
Volume impact calculation:
For Apple, trading approximately $10 billion daily, a $7.2 million creation-related purchase represents 0.07% of daily volume.
For a smaller S&P 500 constituent trading $50 million daily, a $10,000 purchase represents 0.02% of daily volume per creation event.
However, aggregate ETF activity compounds. If 20 S&P 500 ETFs each experience modest creation activity on the same day, the cumulative impact on smaller index members becomes material.
Empirical findings: Research from the Federal Reserve Bank of New York found that stocks with higher ETF ownership experience approximately 12-18% higher daily trading volume than similar stocks with lower ETF ownership, controlling for other factors.
Worked Example: ETF Rebalance Impact on a Mid-Cap Stock
Consider a hypothetical stock, MidCorp Inc., with the following characteristics:
Stock profile:
- Market cap: $8 billion
- Free float: 85% ($6.8 billion)
- Average daily volume: 2 million shares
- Stock price: $40 per share
- Average daily dollar volume: $80 million
ETF ownership:
- Held in 45 ETFs tracking various indexes
- Total ETF ownership: $680 million (10% of float)
Scenario: Quarterly index rebalance
MidCorp's weight increases from 0.25% to 0.30% in a mid-cap index with $50 billion in tracking assets.
Calculation:
- Previous allocation: $50B x 0.25% = $125 million
- New allocation: $50B x 0.30% = $150 million
- Net purchase required: $25 million
Volume impact:
- Daily average volume: $80 million
- Rebalance purchase: $25 million
- Volume spike: 31% above normal
If ETFs execute this rebalance over 2-3 days to minimize market impact, the stock experiences approximately 10-15% elevated volume for that period. Price impact studies suggest this volume surge can move prices by 0.5-1.5% temporarily before mean reversion.
Price Discovery Effects
ETFs affect how underlying stocks incorporate information into prices. The mechanism operates through two channels:
Channel 1: Information transmission
When news affects the broad market, ETF prices often move before individual stock prices. Arbitrageurs then trade the underlying stocks to capture the deviation, effectively transmitting the information.
Study finding: Hasbrouck (2003) found that for S&P 500 stocks, approximately 10-15% of price discovery occurs in SPY rather than in the individual stock markets.
Channel 2: Correlation effects
Stocks with high ETF ownership show higher correlation with each other than their fundamentals would suggest. This occurs because ETF flows affect all basket constituents simultaneously, regardless of individual company news.
Correlation data:
- S&P 500 average pairwise correlation 2000-2010: 0.32
- S&P 500 average pairwise correlation 2015-2024: 0.41
Multiple factors contribute to this increase, but ETF growth explains a measurable portion.
Liquidity During Stress Periods
ETF-stock liquidity relationships behave differently during market stress. Two competing effects emerge:
Effect 1: ETF liquidity buffer
During the March 2020 volatility, many individual stocks experienced order book depletion. ETFs continued trading with relatively narrow spreads, providing an alternative liquidity venue for investors seeking broad exposure.
Spread comparison (March 16, 2020):
- SPY bid-ask spread: 0.04% at peak stress
- Average S&P 500 stock spread: 0.35% at peak stress
Effect 2: Redemption pressure
When investors sell ETFs heavily, authorized participants redeem shares and sell underlying stocks. This creates selling pressure on all basket constituents simultaneously.
March 2020 data:
- SPY experienced $13.1 billion in outflows during March
- This required selling approximately $13 billion in underlying stocks
- Selling occurred regardless of individual company fundamentals
Net assessment: For large-cap stocks, the ETF liquidity buffer typically outweighs redemption pressure. For small-cap stocks with high ETF ownership, redemption-driven selling can represent 20%+ of daily volume during stress periods.
Practical Implications for Stock Investors
Understanding ETF-driven flows helps investors anticipate volume and price patterns:
Rebalance calendar awareness:
Major index rebalances occur on predictable schedules:
- S&P 500: Quarterly (third Friday of March, June, September, December)
- Russell indexes: Annual reconstitution (late June)
- MSCI indexes: Quarterly (late February, May, August, November)
Stocks added to indexes experience buying pressure; stocks removed experience selling pressure. The Russell reconstitution alone moves approximately $70 billion in a single week.
ETF ownership thresholds:
Stocks with ETF ownership exceeding 15% of float face higher correlation with broad market moves and potential liquidity constraints during stress. Check ETF ownership via SEC 13F filings or financial data providers.
End-of-day volume patterns:
Approximately 40% of daily ETF volume occurs in the final 30 minutes of trading, when index funds benchmark their NAV. Underlying stocks experience corresponding volume concentration.
Common Misconceptions
Misconception 1: ETFs always add liquidity
ETFs add trading venues but do not create fundamental liquidity. The underlying stocks remain the source of value. During severe dislocations, ETF prices can diverge from NAV if AP arbitrage becomes uneconomic.
Example: In March 2020, some bond ETFs traded at 5%+ discounts to NAV because APs could not efficiently trade underlying corporate bonds.
Misconception 2: High ETF ownership is automatically problematic
Many highly liquid stocks (Apple, Microsoft) have substantial ETF ownership without liquidity issues. Problems emerge primarily in smaller stocks where ETF flows represent a large share of available trading volume.
Misconception 3: ETF trading always affects underlying stocks
Secondary market ETF trading (investor to investor) does not directly affect underlying stocks. Only creation and redemption activity touches the underlying market. Most ETF volume is secondary market trading.
Checklist: Assessing ETF Impact on Stock Positions
When analyzing a stock, consider these ETF-related factors:
- Check ETF ownership as a percentage of free float (above 15% warrants attention)
- Identify upcoming index rebalance dates that may trigger flows
- Compare the stock's daily volume to potential ETF-driven flow during rebalances
- For small-cap holdings, monitor whether the stock is being added or removed from indexes
- During market stress, assess whether ETF redemption pressure could amplify selling
Source: Federal Reserve Bank of New York Staff Reports on ETF market structure.
Source: S&P Dow Jones Indices and FTSE Russell rebalance calendars and methodology documents.
Source: Hasbrouck, Joel. 2003. Intraday Price Formation in U.S. Equity Index Markets. Journal of Finance.
Source: Investment Company Institute (ICI) ETF asset and flow data.