The importance of determining an ETF’s liquidity

The importance of determining an ETF’s liquidity

For a topic that gets a lot of airtime, exchange-traded fund liquidity is widely misunderstood by people in the investment industry.

And, given the extraordinary times that we are living in today, understanding ETF liquidity has never been more important.

Liquidity has become a key focus for regulators and fund issuers alike.

How do you measure the liquidity of an ETF?

One of the biggest misconceptions with ETFs is the notion that you can generalise their liquidity based on their structure.

ETFs come in many shapes and sizes, tracking a wide range of asset classes, therefore it is impossible to generalise. However, it is not the ETF structure itself that determines the liquidity of the ETF.

Like any mutual fund, it is the underlying assets that the ETF is invested in that determine its liquidity.

Key Points

  • ETF liquidity is important in difficult times
  • It is the underlying assets that the ETF is invested in that determine its liquidity
  • A misconception around ETFs is that those with lower AUM are less liquid

While typically investors can measure a company’s liquidity based on the value that trades on exchange, the same measure cannot be used to gauge an ETF’s liquidity. It is wrong to look at the value of shares traded of the ETF itself.

In order to assess the liquidity of an ETF (that is, how readily you can buy or sell shares of the ETF), you have to look at and assess the liquidity of the assets held by the ETF.

Why do an ETF’s assets determine its liquidity?

For example, a FTSE 100 ETF will hold all of the composite companies matching the percentage weights in the index. If you want to invest £10m in that ETF, the ETF investment manager needs to be able to buy £10m worth of shares in the companies that make up the index.

Therefore, the ETF will have a liquidity profile matching the FTSE 100 companies’ liquidity.

Comparatively, an ETF that invests in a basket of high-yield bonds, will be as liquid as those bonds.

As different asset classes (bonds, equities, commodities, real assets) exhibit different levels of liquidity, their respective liquidity profiles will be reflected in the corresponding ETFs that are designed to provide exposure to them.

Why can ETF exchange liquidity be misleading?

Exchange liquidity is dependant primarily on the ability of the market maker to create and redeem in the primary market, and to hedge their position (buy or sell the ETF’s underlying assets) prior to trading in that market. So, the amount available to buy or sell depends on whether the underlying assets of the ETF can be easily bought and sold.

An ETF can have zero shares traded on exchange or have vast numbers of shares traded on exchange, however, again, what really matters is the underlying assets.This is a crucial part of understanding ETF liquidity.

For example, if a FTSE 100 ETF has zero demand from investors and therefore shows no volume traded, a traditional view of liquidity will say that the ETF is illiquid, that it cannot be easily bought or sold by investors.