When you're investing, whether it's in a piece of gold, a house or
an exchange traded fund (
), one of the most important considerations is how liquid that
asset really is. In other words, how quickly can it be converted
back to cash?
ETFs are a more liquid choice for investors over traditional
mutual funds. Their liquidity allows them to be traded throughout
the day during market hours, which gives institutional and retail
investors a good tool for entering and exiting the market on a
dime. This also gives them the advantage of quickly raising cash
when necessary. [
Are ETFs Becoming Too Complex?
Why does liquidity matter?
William Artzberger for Investopedia notes
the impact reduced liquidity can have on a fund: wider bid-ask
spreads, discrepancies between the net asset value (
) and the underlying securities and a reduction in the ability to
make profitable trades. [
Comparing the Costs of ETFs and Mutual Funds.
Major things that determine ETF's liquidity include: the ETF
make-up, the trading volume of the shares that make up the ETF,
trading volume of the ETF itself and the market climate.
- Asset class is important. ETFs that invest in less liquid
corners of the market, such as real estate, will be less liquid
- Market capitalization matters, too. The most well-known
stocks are usually the most liquid because they're so commonly
owned, whereas small-caps may not be as widely held by
- Risk is a factor. Riskier stocks might be less liquid than
those that carry less risk. For example, lower-grade bonds may be
more difficult to unload than investment-grade ones.
Large investors and advisors have resources at their disposal if
they wish to trade large blocks of thinly traded ETFs. They can
call alternate liquidity providers, brokerages or ETF providers for
assistance with this. [
How to Trade Large Blocks of ETFs Efficiently.
If you're a retail investor, however, you should take into
consideration such factors as trading volume and asset size when
looking for ETFs to incorporate into your portfolio. [
Not All ETFs Are Created Equal.
For more stories about ETFs, visit our
ETF 101 category