Exchange-traded funds (ETFs) are considered to be the more liquid counterpart of mutual funds, offering other benefits in the process. There are several factors that affect the fund’s liquidity.
ETF Composition Factor
ETFs can hold a number of asset classes such as real estate, fixed-income, commodities, and futures. When it comes to equities, most ETFs follow specific indexes, like small/mid/large-cap, growth, or value indexes. Some ETFs also focus on specific market sectors like technology.
Several characteristics of the securities that make up an ETF will also affect its liquidity.
Asset Class
ETFs that invest in less liquid securities like real estate are less liquid than those that invest in assets with more liquidity, like equities and bonds.
Market Capitalization
Market capitalization gauges the security’s value and is defined as the number of shares outstanding of a publicly traded company multiplied by the market price per share. ETFs that invest in equities are generally more liquid if the stocks are widely traded and well-known.
- Large cap stocks are less risky than small/mid-cap stocks.
- In developed economies, securities 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 sector.
- When it comes to fixed-income securities, ETFs that invest in investment-grade corporate bonds and Treasury bonds are less risky than those that invest in lower-grade bonds.
Domestic vs. Foreign Securities
In general, domestic securities are considered to be more liquid than foreign securities. Here are some of the reasons:
- Foreign securities are traded in different time zones.
- Foreign exchanges, along with the countries in which they are, implement different trading laws and regulations, and these things affect liquidity.
- Since most foreign equities are held using American depository receipts, the liquidity of ETFs that invest in ADRs is lower than the funds that don’t.
Trading Volume of ETF Stocks
Aside from market price, trading volume also affects a stock’s liquidity. Trading volume takes place as a direct result of supply and demand. In the financial world, lower-risk securities are more freely traded. Thus, they have higher trading volume and liquidity.
A security that is more actively traded will be more liquid. ETFs that hold actively traded securities will be more liquid than those that do not.
If you trade ETFs with fewer actively traded securities, you will be affected with greater bid-ask spread, while institutional investors may opt to trade using creation units to resolve liquidity issues.
Trading Volume of the ETF
The trading volume of ETF also has some impact on its liquidity. ETFs that follow stocks in the S&P are frequently traded, which means a bit of higher liquidity for the ETFs.
Investment Environment
Since trading activity shows supply and demand for financial securities, the trading environment will also influence liquidity.
For example, if a specific market sector becomes sought after, ETFs in that sector will be in demand, resulting to temporary liquidity issues. Since the companies that issue ETFs can make more ETF shares fairly quickly, such liquidity issues are just short term.
