Liquidity and ETFs

by , 15th June 2018

Liquidity is an important issue for investors. If you’re investing in an illiquid asset, you may find it difficult or expensive to sell that asset, especially if you’re trying to sell when markets are falling quickly.

Many ETFs – especially the largest ones – are very liquid. That’s one of their biggest attractions compared to traditional unit trusts and OEICs. Remember, unit trusts and OEICs set their prices once a day whereas ETFs can normally be bought and sold whenever a relevant stock market is open and trading.

However, the drivers of ETF liquidity are a bit more complicated than some people realise. If you’re trying to find out how liquid a particular stock is, you can look at how many shares are traded each day as well as the bid-offer spread – that’s the difference between the ‘buy’ price and the ‘sell’ price. The tighter the spread, the more liquid a stock is.

But with ETFs, things are a bit more complicated. Smaller investors buy and sell ETF shares via a secondary market – in other words, the stock market. So here liquidity is mainly about the value of ETF shares that are traded and you’re focusing on the bid-offer spread. ETF investors might also check the premium or discount between the ETF’s share price and the net asset value of the ETF. Normally any premium or discount for an ETF is very small, but if an ETF is particularly illiquid then the premium/discount could be larger than you might expect.

The situation is different for larger investors. If they want to do a bigger trade, they can go via the primary market. In other words, they can work with an authorised participant who can create or redeem shares in the ETF. In this situation, the liquidity is driven by the liquidity of the underlying assets in the ETF. If the asset is very liquid, then it’s easy for the authorised participant to create or redeem shares in the ETF, which makes the ETF liquid as well.

As a simple rule, equities tend to be more liquid than bonds and bonds are more liquid than property. Within equities, US and UK larger companies are the most liquid whereas smaller companies in a less mature market, perhaps Africa, are less liquid.

This means that an ETF that invests in US large cap equities should be very liquid even if you don’t see much trading happening on-screen in the secondary market.

In the end, it’s the liquidity on the primary market that is most important. The ETF should be at least as liquid as the least liquid asset in its portfolio.

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