Exchange Traded Fund Liquidity: Factors influence ETF Liquidity

Most investors have traded ETFs on the secondary market by buying and selling them through a brokerage account like TD Ameritrade. However, the actual creation and redemption of ETFs takes place on the primary market between the ETF and authorized participants. By continuously creating and redeeming shares, these authorized participants meet the supply and demand needs of investors on the secondary markets where they actually trade. 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 don’t. Trading Volume of ETF Stocks As market price affects a stock’s liquidity, so does trading volume.

Factors that influence ETF liquidity

These key players bolster liquidity by consistently standing ready to buy and sell shares. Their continuous participation ensures that ETF trading remains fluid and investors execute trades with minimal impact on the market maker price. Essentially, the ease with which the assets are bought or sold impacts the ETF shares. If these assets are highly liquid and readily traded, the exchange traded fund shares naturally inherit the liquidity. Exchange-traded funds (ETFs) offer many benefits to investors, including flexible intraday trading, efficient market access and potentially lower costs. But one of the most important ETF features—their liquidity—is also one of the most widely misunderstood.

ETF Education

By contrast, a market order—an order to buy or sell immediately at the best available current price—may end up being executed at a price that is far higher (or lower) than expected as the order sweeps through standing orders on the order book. Although ETFs have many characteristics that are similar to stocks, liquidity is not one of them. Therefore, it‘s important to look beyond trading volumes and on-screen indicators when assessing ETF liquidity.

Factors that influence ETF liquidity

Even a small, thinly traded stock may, under normal conditions, be traded on the same day and at a reasonable price. This liquidity may not apply to certain foreign stocks, as has occurred in China over the %KEYWORD_VAR% past few months. It also does not apply during market meltdowns, as occurred in 2008 when liquidity for generally all investments—with the exception of Treasuries and other high-quality bonds—dried up.

ETF market capitalisation

Indeed, the analysis presented in this special feature identified a few open issues related to liquidity and counterparty risks in ETFs. This raises the question of whether current regulatory frameworks sufficiently deal with the risks posed by ETFs, or whether further regulatory action should be considered. An ETF’s primary market liquidity measures how easily it can be bought or sold on the stock exchange. This is important for investors to consider because it affects the price of the ETF and the ability to trade it.

Factors that influence ETF liquidity

Changes in currency exchange rates in different accounting and taxation policies outside the U.S. can affect returns. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility. Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors.

Asset Class

The daily volume traded of an ETF is often incorrectly used as a reference point for liquidity. An ETF’s liquidity is determined by the liquidity of the underlying securities whereas trading volume is influenced by the activity of investors. If an ETF invests in securities that have limited supply or are difficult to trade, this may impact the market makers’ ability to create or redeem units of the ETF which may then affect the portfolio’s liquidity. However, most Canadian-listed ETFs predominantly invest in liquid securities that trade on major exchanges around the world. To shed light on this question, a panel analysis is conducted which assesses whether ETF investors are sensitive to changes in counterparty risk and whether their sensitivity changes in stressed market conditions. The liquidity features of ETFs combine characteristics of open-ended investment funds and tradable securities.

With over a billion shares per day traded last year, ETFs account for nearly one-third of all dollar volume traded on U.S. exchanges. Investors and traders in any security benefit from greater liquidity—that is, the ability to quickly and efficiently sell an asset for cash. Investors who hold ETFs that are not liquid may have trouble selling them at the price they want or in the time frame necessary. Moreover, if an ETF invests in illiquid shares or uses leverage, the market price of the ETF may fall dramatically below the fund’s net asset value (NAV). 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.