ETF Liquidity: Why It Matters

From the time when exchange-traded funds (ETFs) originated, they've been 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, have the freedom to trade them during market hours. 

More significantly, institutional investors could use them to quickly enter 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 that make up each ETF.

Lower levels of liquidity lead to greater bid-ask spreads, larger discrepancies between net asset value and the value of the underlying securities, and a decreased ability to trade profitably. Let's look at which ETFs give you the most liquidity and, therefore, the most opportunity for profit. 

It remains true that ETFs have greater liquidity than mutual funds. The degree of an ETF's liquidity depends on a combination of primary and secondary factors.

Primary factors include:

• The composition of the ETF
• The trading volume of the individual securities that make up the ETF

Secondary factors include:

• The trading volume of the ETF itself
• The investment environment

Let's look at each of these in some detail. 

ETFs can be invested in a number of asset classes including real estate, fixed income, equities, commodities and futures. Within the equity universe, most ETFs replicate specific indices, such as large-cap, mid-cap, small-cap, growth or value indexes. There are also ETFs that focus on specific market sectors, such as technology, as well as certain countries or regions.

Generally, ETFs that invest in large-cap, domestically traded companies are the most liquid. Specifically, several characteristics of the securities that make up an ETF will also impact its liquidity. The most prominent are explained below. (See also: An Inside Look At ETF Construction)

Asset class - ETFs that invest in less liquid securities, such as real estate, are less liquid than those that invest in more liquid assets, like equities or fixed income.

Market capitalization - Market capitalization measures a security's value and is defined as the number of shares outstanding of a publicly traded company multiplied by the market price per share. By default, the most well-known publicly traded companies are often large-cap stocks, which are by definition the most valuable of the publicly traded stocks. ETFs that invest in equities are generally more liquid if the securities are well-known and widely traded. Because these stocks are well-known, they are commonly held in investors' portfolios and trading volume on them is high, which makes their liquidity high as well. Conversely, stocks of small- and mid-cap companies are not in as much demand and are not as widely held in investment portfolios; therefore, trading volume and liquidity is lower for these stocks.

Risk profile of the underlying securities - The less risky an asset is, the more liquid it will be. For example:

• Large-cap stocks are considered less risky than small- and mid-cap stocks.
• Securities of companies in developed economies are considered less risky than those in emerging economies.
• ETFs that invest in broad market indexes are less risky than those that focus on specific sectors.
• In the fixed-income world, ETFs that invest in investment-grade corporate bonds and Treasury bonds are less risky than those that invest in lower-grade bonds.

As a result, ETFs that invest in large-cap stocks, developed economies, broad market indexes and investment-grade bonds will be more liquid than those that invest in their riskier counterparts.

Where the securities in an ETF are domiciled - Domestic securities are more liquid than foreign securities for a number of reasons:

• Foreign securities trade in different time zones.
• Foreign exchanges, along with the countries in which they are based, have different trading laws and regulations, which affect liquidity.
• Because most foreign equities are owned through American depositary receipts (ADRs), which are securities that invest in the securities of foreign companies rather than the actual foreign securities themselves, the liquidity of ETFs that invest in ADRs is lower than that of ETFs that don't. 

The size of the exchange in which the securities in an ETF trade also makes a difference. Securities that trade on large, well-known exchanges are more liquid than those trading on smaller exchanges, so ETFs that invest in those securities are also more liquid than those that don't.

As market price affects a stock's liquidity, so does trading volume. Trading volume occurs as a direct result of supply and demand. In the financial world, lower-risk securities are more freely traded, and therefore, have higher trading volume and liquidity. The more actively traded a particular security is, the more liquid it is; therefore, ETFs that invest in actively traded securities will be more liquid than those that do not.

Individuals who invest in ETFs with fewer actively traded securities will be affected by a greater bid-ask spread, while institutional investors may elect to trade using creation units to minimize liquidity issues. (See also: 5 ETFs Flaws You Shouldn't Overlook)

The trading volume of an ETF also has a minimal impact on its liquidity. ETFs that invest in stocks in the S&P 500, for instance, are frequently traded, which leads to slightly greater liquidity. (See also: S&P 500 ETFs: Market Weight Vs. Equal Weight)

Because trading activity is a direct reflection of supply and demand for financial securities, the trading environment will also affect liquidity. For instance, if a particular market sector becomes sought after, ETFs that invest in that sector will be sought after, leading to temporary liquidity issues. Because the companies that issue ETFs have the ability to create additional ETF shares fairly quickly, these liquidity issues are usually short term. (See also: Singling Out Sector ETFs)

As with any financial security, not all ETFs have the same level of liquidity. An ETF's liquidity is affected by the securities it holds, the trading volume of the securities it holds, the trading volume of the ETF itself and, finally, the investment environment. Being aware of how these factors affect an ETF's liquidity, and therefore its profitability, will improve results, which becomes especially important in environments where every basis point counts.