Does size of assets in ETF affect its returns?

One of the most common myths around Exchange traded fund (ETF) is that low daily trading volumes or a small amount of asset under management (AUM) indicate that an ETF is illiquid. Hence many investors wait until such time that the ETF reaches to a considerable size, before investing. This misconception is primarily because ETFs share their characteristics more with stocks rather than mutual fund. However, the reality is that ETFs function fundamentally differently from individual stocks due to their structure and this difference helps in understanding why size may not be the right indicator to enter and exit ETF.

Unlike individual stocks that have a fixed supply of shares in circulation on the secondary market, ETFs are like open-ended investment vehicles. This means that ETFs can issue or withdraw shares on the secondary market based on investor's demand and supply. This means that ETF can be created or redeemed based on the demand and supply for ETF. This ability gives ETFs a unique liquidity profile in comparison with individual stocks, and it helps explain why metrics like ETF assets or trading volume are not particularly helpful in estimating an ETF's liquidity. ETF's liquidity is predominantly determined by the liquidity of the underlying individual securities.

For naïve investors it might all sound like Greek, however, one can easily make sense of ETF liquidity on understanding how ETFs are issued and withdrawn from the secondary market and how this activity impacts its ETF liquidity. ETF shares are created when professional investors—known as “Authorized Participants,” or APs—place an order directly with the ETF manager. In exchange for in-kind or cash payment, the AP receives ETF shares (this entire process comes under primary market for ETF transaction), which can then be sold by the AP into the secondary market. This happens seamlessly every day. All investors can access the secondary market to enter and exit ETF positions. On the back end of that procedure, ETF liquidity providers will utilize the primary market to grow and shrink the assets. Your percentage of holdings makes no difference in your ability to freely enter and exit the fund, without impacting price, daily.