When looking at a stock, most investors will look at the trading volume as an indicator of liquidity. However, the same principle doesn’t exactly apply to exchange traded funds.

An ETF is comprised of tens, hundreds or thousands of individual component securities. Consequently, an ETF’s true liquidity is based on the liquidity of its underlying holdings. [True Liquidity]

“Although the exchange-based liquidity may make the ETF look illiquid, the ETF is very liquid when you take into account the liquidity you can get by trading the underlying basket,” Mike Baradas, Senior Execution Consultant, and Gary Stone, Chief Strategy Officer, write in a Bloomberg research note.

If an ETF is trading at low volumes, an investor can still invest in the ETF by utilizing the services from an alternative liquidity provider.

The Bloomberg analysts note that someone can “source anonymous quotes from a liquidity provider that can tap the liquidity in either a correlated instrument, related derivative or an authorized participant that can trade the underlying basket and submit the ETF ‘Basket’ to the ETF fund administrator to create an ETF.”

Through the ETF structure, a fund sponsor and authorized participant can create or redeem shares by swapping a basket of underlying securities for a unit of ETF shares. [Creations & Redemptions]

“ETPs have the unique advantage of interacting in both the primary (creation/redemption) and secondary (on-exchange) markets,” the analysts added. “What you see on-screen is not the only liquidity that you can get.”

Moreover, Baradas and Stone point out that the underlying basket is not the only source of liquidity.

“Statistical arbitrage liquidity providers may also create ETF markets though the relative value of correlated trading vehicles and related derivatives (swaps, options, futures),” according to the note.

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.