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What is ETF Liquidity and Why does it matter?

The Exchange Traded Funds (ETFs) account for 9% in 2020-21 of India’s total Asset Under Management (AUM) for mutual funds. Although these low-cost, passively managed investment instruments have attracted many investors, they face liquidity issues, and the market regulators are working closely on how to improve ETF liquidity risks.

This article explains ETF liquidity, how you can measure the liquidity of your ETFs, and why it is essential for you. 

What are ETFs? 

ETFs are passively managed funds that invest in various securities and replicate the performance of a particular index. For example, Motilal Oswal NASDAQ 100 ETF tracks most stocks on the NASDAQ index (the second most popular stock exchange in the USA). 

ETFs provide numerous advantages and are a fantastic vehicle for achieving investing objectives. ETFs are available in almost every asset class, from standard investments to alternative assets such as commodities or currencies. 

What is ETF Liquidity?

ETF liquidity is the ease with which an investor can trade ETFs on the exchange. The liquidity concept of ETFs is multilayered because ETFs are essentially asset baskets. The higher the liquidity of the underlying asset that comprises an ETF, the easier it is to redeem the ETF itself.

How liquid are ETFs?

ETFs have two liquidity components – underlying asset liquidity and ETF liquidity.

Underlying Asset Liquidity (Primary Market)

The liquidity of most ETFs is measured from their underlying assets because of their unusual creation and redemption procedure. The underlying asset could be stocks, bonds, gold, or other securities. 

The demand for such assets in the stock market determines the price spread. Existing shares or redemption or issue of new shares complete large orders.

ETF Liquidity (Secondary Market)

The most apparent source of liquidity for ETF is trading activity, although it is not the only one. The average daily volume of shares moved in the secondary market amongst traders adds to an ETF’s liquidity.

Is ETF Liquidity Crucial for the Investor?

If an ETF does not trade enough, it may not be easy to pull out the investment to convert into cash.

Substantial gaps between the bid (price at which investor wants to buy the ETFs) and ask (price at which an investor wants to sell ETFs) are the most indicative signs of the liquidity of an asset. 

ETF liquidity indicator is when there is enough trading interest because that is when you can convert your investment into cash. But how do these indicators change?

For a better understanding, let’s consider the factors that affect ETF liquidity. 

Factors that Cause ETF Liquidity Issues 

A prevalent concern about ETF liquidity in India is insufficient trading volumes. The factors causing ETF liquidity issues are as follows:

ETF Composition

ETFs invest across asset classes and track specific indices such as stock, bond, or commodity. The lesser an asset’s investment risk, the more liquid it is, making buying and selling such funds easier. The general liquidity of the assets that comprise it influences ETF liquidity.

The Trading Volume of the ETF’s Assets

Supply and demand forces influence trading volume. Low-risk securities are in more demand, making them easier to trade. This frequently results in a high trading volume. And if the trading volume of an ETF’s core assets is significant, the ETF’s total liquidity rises.

The Trading Volume of the ETF

The ETF has its trading volume and the trading volume of its underlying assets, and the overall type of assets in the ETF basket determines its trading volume. For instance, large-cap stock ETFs trade more frequently than small-cap ETFs resulting in lesser liquidity in the small-cap stock ETFs.

How to know if your ETFs are Liquid?

Look for the below factors in your ETF to better understand if your ETFs are liquid or not: 

  • Liquidity of an underlying asset
  • The bid-ask spread

An ETF’s trading volume is not the same as its liquidity. You can better define ETF liquidity by accessing the liquidity of the underlying securities rather than by monitoring the investors’ activities. 

For example, you have a bond ETF, and to check whether it is liquid or not, you need to study the bond liquidity. Although bonds are less riskier than stocks, bonds carry liquidity risks since they mature at a particular date and certain bonds have a lock-in period. Hence, since bonds are primarily illiquid, your bond ETF will also be less liquid. 

The bid-ask spread is the gap between an ETF’s bid price and the ask price. It is the most direct indication of an ETF’s liquidity. 

The spread is the cost of doing business, and it is the difference between the price you would pay to buy an ETF and the amount you would receive if you sold it. The lower the spread, the more liquid your ETFs will be, whereas the higher the spread, the lesser liquid your ETFs will be.

Conclusion

In terms of assets, product releases, and adoption by institutional and high-net-worth investors, the Indian ETF sector has expanded and matured significantly during the last ~18 years. The industry has also benefited from the market and regulatory tailwinds.

However, the business is still in its infancy regarding investor awareness, liquidity, and market structures.

Given the benefits of ETFs (low cost, transparency, and liquidity), there is significant room for market expansion, increased awareness, and improved allocations in retail portfolios.

Discover stocks that suit certain filter criteria and dive into details to check their WealthBaskets.

At WealthDesk, we offer you readymade WealthBaskets consisting of stocks or ETFs reflecting an investment strategy or theme designed explicitly by the SEBI-approved investment professionals and make your investment journey hassle-free.

FAQs

Why is ETF liquidity important?

Liquidity is crucial since it refers to the capacity to sell an asset for cash quickly and efficiently. Investors who own non-liquid ETFs may have difficulty selling them at the price they want.

Why are ETFs more liquid than mutual funds?

ETFs are more liquid than mutual funds since they trade on the stock exchanges. They can trade like stocks without any redemption process or a lock-in period.

How do you calculate the liquidity of an ETF?

The bid-offer spread is the most visible sign of an ETF’s liquidity. Higher spread indicates low liquidity, while the tight gap in the spread means higher liquidity.

What is ETF Liquidity and Why does it matter?

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What is ETF Liquidity and Why does it matter?

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