There are many investment options based on the stock market. For investors who are looking for options beyond direct equity, there are mutual funds of different kinds. But, like all investment options, mutual funds may also not be ideal for some investors. An excellent alternative, in such a scenario, would be to opt for Exchange Traded Funds (ETFs). General investor perspective places ETF liquidity above mutual fund liquidity.

To fully understand the details of ETF liquidity and the degree of ETF liquidity risk, it’s important to first begin at the basics. Let us take a look at what ETFs are, before we move on to answer the question of ‘what is ETF liquidity?’

What are Exchange Traded Funds (ETFs)?

ETFs are a lot like mutual funds. They pool the financial resources of multiple investors and use those pooled funds to purchase a variety of monetary assets like shares, derivatives, bonds and other securities. So far, they seem similar to mutual funds, don’t they? The difference lies in the fact that unlike mutual funds, ETFs are not actively managed by fund managers. And unlike mutual funds, ETFs are listed on stock exchanges. So, they can also be easily bought and sold on those exchanges, just like shares.

ETF liquidity also differs from the liquidity of mutual funds. The former is considered to be more liquid. Let’s get into those details and understand the concept of ETF liquidity better.

What is ETF liquidity?

ETF liquidity is the ease with which a particular Exchange Traded Fund (ETF) can be bought and sold on the exchange. Since ETFs are basically baskets of multiple assets, the concept of ETF liquidity is also multi-layered. Broadly speaking, ETF liquidity has two main components.

– The liquidity of the ETFs traded on the exchange

– The liquidity of the individual assets in an ETF

Generally, the more liquid the individual assets that make up an ETF are, the easier it is to redeem the ETF itself. This establishes a direct relationship between the liquidity of the constituent assets and the liquidity of the ETF itself.

ETFs in the primary and secondary market

Exchange Traded Funds can be traded in the primary as well as the secondary markets, just like shares. Typically, only institutional investors trade in the primary market through Authorised Persons (APs). These are investors with deep pockets, and they trade in tens of thousands of units at a time. Such heavy-duty transactions have the capacity to influence the supply of ETFs in the secondary market, because institutional investors either acquire or redeem a large basket of assets through ETFs.

In the secondary market, non-institutional investors or retail investors primarily trade through the exchanges, just like how shares are bought and sold. There are many factors that influence ETF liquidity in the primary and secondary markets.

What are the elements that influence the liquidity of ETFs?

There are primarily four factors that influence the liquidity of ETFs.

1. The way the ETF is composed

2. The trading volume of the assets in the ETF

3. The ETF’s own trading volume

4. The general investment ecosystem

Let us look at each of these factors in detail.

The way the ETF is composed

ETFs invest in multiple asset classes. Equity ETFs, for instance, may replicate specific indices like large-cap, small-cap or growth indices. Other ETFs may focus on market sectors like real estate or IT. The general liquidity of the assets that make up an ETF influence its liquidity.

This is also true regarding ETF liquidity risk. The lower the investment risk of an asset, the more liquid it is. This basically lowers the ETF liquidity risk on the whole, since it is easier to buy or sell such funds.

The trading volume of the assets in the ETF

Trading volume is influenced by supply and demand forces. Low risk securities are more in demand, and so, they are easier to trade. This often translates to a high trading volume. And if the trading volume of the constituent assets in an ETF is high, the ETF’s overall liquidity goes up.

The ETF’s own trading volume

In addition to the trading volume of the constituent assets, the ETF itself has its own trading volume. This is influenced by the general category of assets that the ETF basket consists of. For instance, large-cap ETFs may be traded more frequently than small-cap ETFs. This results in lower liquidity for the latter than the former.

The general investment ecosystem

The overall market sentiment, the trends shaping up the specific sectors associated with the ETF, and the general state of the economy may also temporarily influence ETF liquidity. For investors looking to invest in Exchange Traded Funds, it’s a good idea to take all of these factors into consideration.

Conclusion

It’s important to keep in mind that while ETFs as an asset class may be more liquid than many other investment options, not all ETFs possess the same level of liquidity. Some are more liquid than others. So, investors would do well to look at all the factors influencing the liquidity of a fund before including it in their portfolio.