How is liquidity of ETF different from that of index fund?

ETFs and index funds have more difference in their characteristics than what is common between them. An index fund, which mimics a particular index invests in all the stocks and in the same proportion as in the scheme's benchmark index. An ETF too does the same, but its mechanism is different. An ETF creates units, which are then available on the stock market for sale where investors like you can buy them.

Exchange traded funds (ETFs) have more resemblance to stocks than mutual fund schemes. Therefore, when it comes to the liquidity of an ETF, investors relate it with the liquidity of individual stocks and hence larger the trading volume, better the liquidity of an ETF. Nevertheless, there is more that needs to be checked in case of ETFs. Liquidity in case of ETF is taken at two stage, first at the primary market and second at the secondary market.

Most of the retail investors trade in the secondary market, which means trading the ETFs share that currently exists. This is what most of us see in our trading screen. Beyond this, there is another type of liquidity that is primary liquidity, which means ETFs can be created or redeemed depending upon the demand of ETFs. So, the primary liquidity is concerned with how much ease new units of ETFs are created and redeemed to adjust for the change in demand of the ETFs in the secondary market.

The determinants of primary market liquidity are different than the determinants of secondary market liquidity. In the secondary market, liquidity is generally a function of the value of ETF shares traded; in the primary market, liquidity is more a function of the value of the underlying shares that back the ETF.

In the case of index funds, investors can invest any amount in the index funds. He just has to sign a cheque for that amount. The fund manager will then go and buy the necessary quantity of shares from the secondary market. ETF investors use a measure called implied liquidity to assess how much money can be invested into a given ETF on a daily basis. For a retail investor, liquidity in the secondary market is important and he needs to check if the liquidity is enough so as to enter and exit the ETF without much of impact.