When we talk about stocks, we often think its liquidity is all about trading volume and irregularity. The more, the better. But that is not the case for exchange-traded funds (ETFs).

ETFs were broadly considered as more liquid alternative to mutual funds. Investors can obtain the same diversification they could get with indexed mutual funds. Unlike mutual funds, ETFs can also be traded during market hours. Having said that, it endures price volatility throughout a trading day as these are purchased and sold. Now, let this article break down the important points to discuss why ETF’s liquidity matters.

Composition of ETFs. ETFs can be invested in numerous asset classes such as commodities, equities, fixed income, futures, and real estate. In equity, most ETFs are placed in certain indexes: small-cap, mid-cap, large-cap, growth, or value. Others concentrate on particular market sectors such as technology, or on some countries or regions.

Generally speaking, the most liquid ETFs are the ones invested in large-cap, domestically-traded firms. Various characteristics of the securities in an ETF will also affect its liquidity. Some of the popular ETFs are explained below:

  • Asset Class - ETFs in less liquid securities are less liquid than those in equities or fixed income
  • Market Capitalization - It pertains to the security’s value based on the number of shares outstanding of a publicly-traded company times the market price per share. Large-cap stock are the most well-known publicly traded firms by default. ETFs in equities are more liquid than other types of ETFs if the securities are prominent and widely traded. Investors commonly hold well-known stocks in their portfolios, and trading volume on such stocks is high, making its liquidity high, too.
  • Risk Profile of the Underlying Securities - The less risky an asset is, the more liquid it is. For instance, securities of firms in developed economies are considered less risky than those in emerging economies.
  • Location of the Securities in an ETF - For numerous reasons, domestic securities are more liquid than foreign ones. One reason is foreign securities trade in several time zones. Another is foreign exchanges have differing trading laws and regulators; hence, it affects liquidity.

Factors Influencing Liquidity of ETFs. The extent of an ETF’s liquidity depends on a combination of primary and secondary factors. Primary factors include its composition, and the trading volume of every security on the ETF. Secondary factors are the ETF’s trading volume and the investment environment.

Trading Volume of ETF Stocks. Market price impact the liquidity of a stock. Same thing with trading volume, the effect of supply and demand. Securities with lower risk are more freely traded in finance; thus, it have greater trading volume and liquidity. The more actively traded a security is, the more liquid it is. Conversely, ETFs investing in fewer actively traded securities will be affected by a higher bid-ask spread. Institutional investors may opt to trade using creation units in order to reduce liquidity issues.

Trading Volume of ETFs. The trading volume of an ETF minimally influences its liquidity. For example, ETFs in stocks in the S&P 500 are often traded, leading to slightly higher liquidity. But not all ETFs are created equally.

Investment Environment. The trading environment will affect its liquidity since trading activity is directly related to supply and demand for financial securities. For example, if most traders look after a specific market sector, ETFs investing in that sector will be sought after, resulting to temporary liquidity issues. Because firms that issue ETFs can create additional ETFs swiftly, such issues do not last long.