How Liquidity Impacts ETFs

January 28th at 12:15pm by Tom Lydon

Liquidity is a big factor when it comes to choosing the right exchange traded fund. Low liquidity in a fund can present problems and even cut into returns.

“Primary liquidity relates to the trading characteristics of the ETF. The larger the ETF, the more likely it is to trade in higher volumes on a regular basis, all else being equal. ETFs enjoying a high primary liquidity tend to be the larger ones in AUM terms, perhaps owing, in part, to the fact that the market overall values that high primary liquidity aspect,” Yves Rebetez wrote for Financial Post.

There is another type of liquidity that exists in ETFs. Secondary liquidity is the liquidity of the exposure found in the ETF and is where the true market liquidity of the ETF resides, reports Rebetez. The structure of an ETF allows brokers or market makers to create or redeem additional shares in the fund, which in turn impacts liquidity.

“For smaller and less-heavily traded ETFs, there is a different trading dynamic. Large trades, those in 50,000 increments, can generally be executed very effectively. This seems counter-intuitive when compared with investing in small-cap stocks. Generally, the larger an order size for an illiquid or small market-cap stock, the larger the difference between the last quoted price and the actual price at which you will be able to execute a trade,” Paul Justice wrote for Morningstar.

When an investor selects an ETF, they should look for high daily trading volume, a high level of assets over management (at least $1 billion) and compare the cost of the basket of stocks that the ETF holds versus the price of the actual ETF.

ETFs that focus on large-cap, domestically-traded companies are usually the most liquid. The characteristics of the stocks that the ETF holds such as market capitalization and risk profile will typically indicate the liquidity of a fund.

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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