With the sudden proliferation of ETFs, investors are now spoiled for options. Many ETFs may overlap and cover similar areas of the market. Consequently, it is important for investors to understand how the underlying indices work and what makes one ETF’s holdings different from another. For instance, traditional beta-index ETFs may reflect prominent market-cap-weighted indices, but the new breed of strategic- or smart-beta ETFs are backed by customized indices with targeted strategies.
Additionally, potential investors should understand that traditional notions of liquidity may not apply to ETFs. Since ETFs act as the sum total of their underlying holdings, an ETF’s true liquidity is based off the total liquidity in its underlying components. Consequently, even if an ETF shows light volume, it may still be a liquid asset since its underlying holdings are actively traded. [Volume is not the Best ETF Demand Indicator]
However, liquidity problems do arise when the underlying assets show low liquidity. For instance, as banks and institutions hoard fixed-income securities, investors have turned to bond ETFs in response to the lack of liquidity across the underlying markets, potentially setting the stage for liquidity problems if ETFs experience large redemptions. [Liquidity Concerns in Corporate Bond ETFs]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.