When exchange-traded funds (ETFs) were originated, they were basically and widely viewed as a more liquid alternative to mutual funds. Not only could investors gain the same broad diversification that they could with indexed mutual funds but, unlike mutual funds, they could also trade them during market hours.
More significantly, institutional investors could use them to quickly enter and exit positions, making them a valuable tool in situations where cash needed to be raised quickly. While individual investors have little recourse when liquidity decreases, institutional investors who use ETFs may avoid some liquidity issues through buying or selling creation units, which are baskets of the underlying shares which make up each ETF.
Lower levels of liquidity lead to greater bid-ask spreads, larger discrepancies between net asset value and the value of the underlying securities and a decreased ability to trade profitably.
Factors That Influence ETF Liquidity
It remains true that ETFs have greater liquidity than mutual funds.
Primary factors include:
- The composition of the ETF
- The trading volume of the individual securities that make up the ETF
Secondary factors include:
- The trading volume of the ETF itself
- The investment environment
Generally, ETFs that invest in large-cap, domestically traded companies are the most liquid. Specifically, several characteristics of the securities that make up an ETF will also impact its liquidity. Conversely, stocks of small and mid-cap companies are not as much in demand and are not as widely held in investment portfolios; therefore, trading volume and liquidity is lower for these stocks.
As a result, ETFs that invest in large-cap stocks, developed economies, broad market indexes and investment-grade bonds will be more liquid than those that invest in their riskier counterparts.
Individuals who invest in ETFs with fewer actively traded securities will be affected by a greater bid-ask spread, while institutional investors may elect to trade using creation units to minimize liquidity issues. (Despite their popularity, these funds have downsides that investors should consider. Learn more in Five ETFs Flaws You Shouldn’t Overlook.)
Conclusion
As with any financial security, not all ETFs have the same level of liquidity. An ETF’s liquidity is affected by the securities it holds, the trading volume of the securities it holds, the trading volume of the ETF itself and finally, the investment environment. Being aware of how these factors affect an ETF’s liquidity, and therefore its profitability, will improve results, which becomes especially important in environments where every basis point counts.