When you’re investing, whether it’s in a piece of gold, a house or an exchange traded fund (ETF), one of the most important considerations is how liquid that asset really is. In other words, how quickly can it be converted back to cash?
ETFs are a more liquid choice for investors over traditional mutual funds. Their liquidity allows them to be traded throughout the day during market hours, which gives institutional and retail investors a good tool for entering and exiting the market on a dime. This also gives them the advantage of quickly raising cash when necessary. [Are ETFs Becoming Too Complex?]
Why does liquidity matter?
William Artzberger for Investopedia notes the impact reduced liquidity can have on a fund: wider bid-ask spreads, discrepancies between the net asset value (NAV) and the underlying securities and a reduction in the ability to make profitable trades. [Comparing the Costs of ETFs and Mutual Funds.]
Major things that determine ETF’s liquidity include: the ETF make-up, the trading volume of the shares that make up the ETF, trading volume of the ETF itself and the market climate.
- Asset class is important. ETFs that invest in less liquid corners of the market, such as real estate, will be less liquid themselves.
- Market capitalization matters, too. The most well-known stocks are usually the most liquid because they’re so commonly owned, whereas small-caps may not be as widely held by investors.
- Risk is a factor. Riskier stocks might be less liquid than those that carry less risk. For example, lower-grade bonds may be more difficult to unload than investment-grade ones.
Large investors and advisors have resources at their disposal if they wish to trade large blocks of thinly traded ETFs. They can call alternate liquidity providers, brokerages or ETF providers for assistance with this. [How to Trade Large Blocks of ETFs Efficiently.]
If you’re a retail investor, however, you should take into consideration such factors as trading volume and asset size when looking for ETFs to incorporate into your portfolio. [Not All ETFs Are Created Equal.]
For more stories about ETFs, visit our ETF 101 category.
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.