ETF Liquidity Myth

When exchange-traded funds (ETFs) originated, they were 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.

Institutional investors could use them to quickly enter into 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. Large brokerage houses such as Morgan Stanley and Salomon Smith Barney also occasionally act as authorized participants when a client makes a large order. Based on their ability to purchase the underlying stocks in the ETF, they can create a huge number of ETF shares instantly with little difficulty in a liquid index like the S&P 500.

Not surprisingly, ETFs based on indexes that also have derivatives tied to them have even slimmer bid-ask spreads. The reason is that there is heightened interaction between the specialists, market makers, and arbitrageurs. In other words, ETF shareholders benefit from this increased competition because it narrows spreads. More firms are researching ETF bid-ask spreads, and the results confirm that ETFs tied to liquid indexes have very small spreads.

However, if you have confidence in U.S. market liquidity then you should feel safe using existing broad-based domestic ETFs, and their history thus far bears that out. We would add that a wait-and-see attitude could be beneficial for potential ETFs tied to illiquid indexes – private securities or municipal bonds, for example.

Factors That Influence ETF Liquidity

It remains true that ETFs have greater liquidity than mutual funds. Some investors appear to believe that the liquidity of an ETF is dependent on the fund’s average trading volume, or the number of shares traded per day. However, this is not the case. Rather, a better measure of ETF liquidity is the liquidity of the underlying stocks in the index. Although ETFs trade like stocks, trading volume does not give good insight into how easily they trade, because the underlying securities make the difference. Below are some factors that affect the liquidity of ETFs.

Underlying Asset: ETFs which have less liquid equities as there underlying assets are usually less liquid than those have liquid equities as underlying asset.

Diversification: ETFs which invest in broad diversified market indexes are usually more liquid than which invest in specific sectors.

Market Capitalization: ETFs which invest in large-cap stocks are usually more liquid than mid-cap and small-cap tracking ETFs.

Fixed Income Securities: ETFs which have fixed income securities like treasury bonds, corporate bonds, etc as underlying instruments are more volatile and is also less risky.

Economy: ETFs which track indexes of emerging world economies are usually considered less liquid than that of developed world economies. Also ETFs investing in domestic securities are more liquid than foreign ones.

Trade Volume: Although not a major factor, increase in trading volume of ETF positively contributes to the liquidity of it.

Trading volume of underlying stocks: The more the underlying stocks are traded the higher the liquidity of ETF.

Time, News and Market Forces: These ever changing factors affect the liquidity of all the traded instruments including ETFs.