An exchange-traded fund, or ETF, is a type of security that tracks an underlying basket of assets. The liquidity of an ETF is critical to its performance, and traders must understand what factors influence this liquidity. We’ll take a closer look at what affects the liquidity of ETFs, and we’ll discuss some tips for trading these securities.
What liquidity is and why it matters
To understand the liquidity of an ETF, we first need to understand what liquidity is. Liquidity measures how easy it is to buy or sell an asset without affecting its price. A very liquid asset can be traded quickly and at a low cost, while an asset that is less liquid may take longer to trade and incur higher costs.
Traders often use ETFs to gain exposure to a particular market or sector. For example, the SPDR S&P 500 ETF (SPY) tracks the performance of the S&P 500 Index, giving traders a simple way to invest in large-cap US stocks. However, ETFs can also be more specific, such as the iShares China Large-Cap ETF (FXI), which focuses on large Chinese companies.
The liquidity of an ETF can have a significant impact on its performance. A highly liquid ETF will be less volatile and can trade at a closing price to its net asset value (NAV). On the other hand, a less liquid ETF may be more volatile and trade at a more comprehensive premium or discount to its NAV.
The benefits of a liquid ETF
There are several benefits of investing in a liquid ETF. First, liquid ETFs tend to be less volatile than their fewer liquid counterparts. It is because these ETFs have more buying and selling activity, which helps stabilise their prices.
Liquid ETFs can trade at a closing price to their Net Asset Value (NAV) than less liquid ETFs. The NAV is the value of an ETF’s underlying assets, minus any fees and expenses. When an ETF trades at a discount to its NAV, you can buy the ETF for less than the value of its underlying assets. Conversely, when an ETF trades at a premium to its NAV, you’ll pay more for the ETF than the value of its underlying assets.
In general, you’ll want to buy an ETF when it’s trading at a discount to its NAV, and you’ll want to sell when it’s trading at a premium. However, this isn’t always possible with less liquid ETFs, and it is because the prices of these ETFs can move very quickly, making it difficult to buy or sell at the desired price.
Liquid ETFs tend to have lower expenses than their fewer liquid counterparts, and this is because the larger trading volumes in these ETFs allow for economies of scale that can help offset the costs of running the ETF.
Finally, liquid ETFs tend to be more transparent than less liquid ETFs. It is because the prices of these ETFs are more readily available, and it’s easier to get information on their holdings; see this here https://www.home.saxo/en-sg/products/etf.
How to measure the liquidity of an ETF
There are a few different ways to measure the liquidity of an ETF. One way is to look at the bid-ask spread. The bid-ask spread is the difference between the highest price that someone is willing to pay for an ETF (the “bid price”) and the lowest price that someone is willing to sell it for (the “ask price”). A lower bid-ask spread indicates more liquidity, as there is a minor difference between the buy and sell prices.
Another way to measure liquidity is to look at the trading volume of an ETF, and it is simply the number of shares that have been traded in a given period. In general, higher trading volumes indicate more liquidity.
Factors that can impact an ETF’s liquidity
There are a few factors that can affect the liquidity of an ETF, including:
The size of the ETF- A larger ETF is typically more liquid than a smaller one, and this is because there is more demand for the larger ETF and because there are more shares outstanding.
The underlying assets- The underlying assets of an ETF can also affect its liquidity. For example, an ETF that tracks a broad index like the S&P 500 will be more liquid than an ETF that tracks a less well-known index.
The trading volume- The trading volume of an ETF can give us insight into its liquidity. A highly traded ETF will typically be more liquid than one that is not as heavily traded.
The bid-ask spread- The bid-ask spread can also be a good indicator of liquidity, and a narrower spread indicates more liquidity, as there is a minor difference between the buy and sell prices.