ETF Liquidity: Why It Matters

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In exchange, the ETF sponsor provides the market maker with ETF units of equal value, which the market maker subsequently sells publicly on the business to meet investor demand. Sometimes, low-volume ETFs can have strong market depth due to presence of active market makers making bids and offers. Also, if the ETF has active market makers, it is possible that your order (limit) gets executed even though it may not show up in the order book. Because the trading activity is a direct reflection of supply and demand for financial securities, the trading environment will also affect liquidity.

For current holdings, please visit each Fund’s individual overview page. As a general rule, trading at times when it is difficult for market makers and other institutional investors to hedge underlying securities in an ETF will likely result in wider spreads and less efficient trades. This is typically the case just after U.S. equity markets open and just before they close.

Why is ETF liquidity important

The underlying basket is the true baseline of ETF liquidity and can offer investors a sense of ETF shares that could be traded in the future. There is a lower chance of ETF share prices being higher or lower than their actual value. ETFs trade throughout the day at a price close to the price of the underlying securities, so if the price is significantly higher or lower than the net asset value, arbitrage will bring the price back in line. Unlike closed-end index funds, ETFs trade based on supply and demand, and market makers will capture price discrepancy profits. In times of market stress or volatility, illiquid ETFs may experience wider bid-ask spreads and higher price volatility, making it difficult for investors to execute trades at desired prices.

Let’s look at how ETF liquidity works and explore an example of the liquidity of an ETF that has low assets under management (AUM) as well as low trading volume. ETFs are more liquid than mutual funds since they trade on the stock exchanges. They can trade like stocks without any redemption process or a lock-in period. More significantly, institutional investors could use ETFs to quickly enter and exit positions, making them a valuable tool in situations where cash needed to be raised quickly. Liquid ETFs provide investors with the flexibility to adjust their investment positions as market conditions change. They can easily enter or exit positions without being constrained by illiquidity.

These types of speculative investments need to be carefully evaluated. If the ETF is held for a long time, the actual loss could multiply fast. Longer-term investors could have a time horizon of 10 to 15 years, so they may not benefit from the intraday pricing changes. Some investors may trade more due to these lagged swings in hourly prices.

  • The information contained within should not be a person’s sole basis for making an investment decision.
  • Secondly, high liquidity reduces the bid-ask spread, resulting in lower transaction costs.
  • Also, if the ETF has active market makers, it is possible that your order (limit) gets executed even though it may not show up in the order book.
  • While liquidity in the secondary market depends upon the weight of ETF shares traded.
  • Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Of course, ETFs have pitfalls as well, from low liquidity in some cases to the risk and complexities of the most speculative varieties of exchange-traded funds. Identifying the advantages and disadvantages of ETFs can help investors decide whether these securities make sense for their portfolios, and to maximize their rewards while reducing the risks. Liquidity is one of the most important features attracting a diverse group of investors to exchange traded funds (ETFs).

The liquidity concept of ETFs is multilayered because ETFs are essentially asset baskets. The higher the liquidity of the underlying asset that comprises an ETF, the easier it is to redeem the ETF itself. ETFs are passively managed funds that invest in various securities and replicate the performance of a particular index. For example, ETF Liquidity Provider Motilal Oswal NASDAQ 100 ETF tracks most stocks on the NASDAQ index (the second most popular stock exchange in the USA). A leveraged ETF is a fund that uses financial derivatives and debt to amplify the returns of an underlying index. Certain double or triple leveraged ETFs can lose more than double or triple the tracked index.

Why is ETF liquidity important

We can look at the trading volume of a stock to see how liquid it is. However, it’s more reliable to observe other factors of an ETF since its shares are not closed. This is because shares of stocks are closed—new shares cannot be created freely.

Costs such as a management fee, fund accounting and trading expenses, and load fees for sale and distribution. The most popular ETFs trade with more liquidity than most stocks, meaning there are always plenty of buyers and sellers keeping the bid-ask spreads low. The liquidity of the underlying securities and the liquidity of the ETF in the primary market share a direct relationship. The more efficiently an AP can access the underlying market, the more ETF shares it can create and redeem. When executing a large trade that runs into thousands of ETF shares, investors can circumvent an illiquid secondary market by directly engaging with the AP to create new shares in the primary market. The primary market is concerned with the high demand and supply of institutional or non-institutional investors who buy and sell ETF shares in bulk in tandem with the Authorized Participant.

Why is ETF liquidity important

Thomas’ experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning. In the event of redemption, the process can be reversed when the supply of units exceeds demand. No content on the Webull Financial LLC website shall be considered as a recommendation or solicitation for the purchase or sale of securities, options, or other investment products. All information and data on the website is for reference only and no historical data shall be considered as the basis for judging future trends. Our clearing firm Apex Clearing Corp has purchased an additional insurance policy.

Matthews International Capital Management, LLC is the advisor to the Matthews Asia Funds. The ETF has its trading volume and the trading volume of its underlying assets, and the overall type of assets in the ETF basket determines its trading volume. For instance, large-cap stock ETFs trade more frequently than small-cap ETFs resulting in lesser liquidity in the small-cap stock ETFs.

The general liquidity of the assets that comprise it influences ETF liquidity. The most apparent source of liquidity for ETF is trading activity, although it is not the only one. The average daily volume of shares moved in the secondary market amongst traders adds to an ETF’s liquidity.

Often, investors examine average daily volume (ADV) of an ETF as a basis for liquidity. ETF liquidity is how easily shares can be bought or sold without impacting the price. While ADV, or historical on-exchange volume, over a specific time-period adds to the overall liquidity profile of the ETF, it’s important for investors to look through the ETF structure to the underlying basket of securities.

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