Updated on January 21, 2023
On the topic of investing, one of the most important things to consider is liquidity which is why many investors ask the question:
ETFs are a type of investment that trade like a stock on an exchange. They are a popular choice for investors because they offer the ability to diversify one’s portfolio and are liquid, meaning they can be sold quickly and easily.
ETFs, receive praise for their liquidity, which refers to how easy it is to buy and sell the fund. That liquidity is one of the key reasons why ETFs have become so popular in recent years. After all, who wants to remain in a fund they can’t sell when they need to?
Why does liquidity matter?
For one, it allows investors to trade in and out of positions quickly and easily. If you need to raise cash for an emergency, you don’t want to be stuck in an illiquid ETF that you can’t sell.
Liquidity also matters because it affects the price of the ETF. If there are more buyers than sellers, the price will go up.
The price of an ETF is determined by the supply and demand in the market. If there are more buyers than sellers, the price will go up. On the other hand, the price will go down if there are more sellers than buyers. Thus, liquidity is important because it affects the price of an ETF.
Factors that determine ETF liquidity
The number of trading days
The number of days an ETF trades on the market affects its liquidity. A higher number of days means more activity and, therefore, more liquidity. This is because more buyers and sellers are participating in the market. However, a lower number of days also has its benefits. For example, it may mean that fewer people are trading the ETF, but it also means that fewer people can influence the price.
The time of day
ETFs are generally more liquid during regular market hours than during after-hours trading. The time of day can have a significant effect on the liquidity of an ETF. For example, trading activity in the US tends to be highest during the morning hours, so ETFs that track US markets may be more liquid during this time. Conversely, trading activity in Asia tends to be highest during the evening hours, so ETFs that track Asian markets may be more liquid during this time.
The underlying assets
The underlying asset determines the liquidity of an ETF. If the underlying assets are illiquid, the ETF will be less liquid. If the underlying asset is highly liquid, then the ETF will be as well. However, if the underlying asset is not liquid, the ETF will also be illiquid. Therefore, it is important to consider the liquidity of the underlying asset when investing in an ETF.
Size of the ETF
The size of an ETF affects its liquidity, with larger funds generally having more liquid shares. This is because large funds have more assets under management and can trade more shares without affecting the price. The average size of an ETF is about $175 million, but some can be as large as $10 billion.
The composition of an ETF affects its liquidity in a few ways:
- If the ETF tracks a broad index, it will generally be more liquid than if it tracks a narrower index or sector.
- If the ETF holds mostly large-cap stocks, it will generally be more liquid than if it holds mostly small-cap stocks.
- If the ETF is heavily traded, it will generally be more liquid than if it is not.
ETF Asset class
While all ETFs are technically liquid, some are more liquid than others. The liquidity of an ETF can be affected by the type of asset it holds. For example, a bond ETF will generally be more liquid than a commodity ETF. This is because more buyers and sellers are in the bond market than in the commodity market. Similarly, an ETF that tracks a highly traded stock index will be much more liquid than an ETF that tracks a less traded commodity.
ETF market capitalisation
ETFs are generally more liquid than their underlying holdings, but this is not always the case. One factor that can affect an ETF’s liquidity is the market capitalization of its underlying holdings. Generally, ETFs with holdings that are primarily made up of large-cap stocks will be more liquid than those with holdings mostly made up of small-cap stocks.
Some of the most liquid ETFs are SPY (SPDR S&P 500), QQQ (Invesco QQQ Trust), and IWM (iShares Russell 2000). These funds offer investors exposure to large-cap, tech, and small-cap stocks. They are extremely popular and trade frequently, making them some of the most liquid ETFs available.
Primary Market ETF Liquidity
An ETF’s primary market liquidity measures how easily it can be bought or sold on the stock exchange. This is important for investors to consider because it affects the price of the ETF and the ability to trade it. A highly liquid ETF will have more buyers and sellers and will trade at a closer price to its net asset value (NAV).
Secondary Market ETF Liquidity
Secondary market ETF liquidity refers to the ability of ETF investors to buy and sell shares on the secondary market. This liquidity is important for two reasons: first, it allows investors to buy and sell ETF shares without going through the ETF provider; second, it allows investors to trade ETF shares without having to wait for the fund to issue or redeem new shares.
Before investing in ETFs, it is important to understand how liquid they are.
While ETFs are generally more liquid than other investments, there is still a risk that you may not be able to sell your ETFs when you want to.
Make sure you research and understand the risks before investing in ETFs.
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