Everything you need to know about liquidity for exchange-traded funds

If the ETF is often trading at less than large volume, this is called high liquidity. The more ETF trading, the lower the trading costs. Learn about the liquidity of exchange-traded funds and how you can evaluate it.

The more you trade ETFs, the more important it is to understand how liquid your holdings are. Liquidity – when it comes to ETFs – refers to how easy it is to trade and at what cost.

The most obvious indicator of an ETF’s liquidity is its spread. The spread is the cost of doing business and is the difference in the price you would pay to buy an ETF compared to the price you would get if you sold it (just like exchanging foreign currency at an airport). The spread is chosen as a commission by the market makers – the financial intermediaries that match buyers and sellers on the exchange.

The more efficient market makers can execute buy orders from buyers and sellers, the narrower the spread for all financial products. The most important factors affecting the liquidity of an ETF are:

• Liquidity of the ETF’s core assets This is important because the high demand for the ETF can easily be met by creating new units in the fund. For example, if the underlying asset is FTSE 100 shares, it is relatively easy for authorized participants to enter the market and buy FTSE 100 shares that can be converted into additional shares in FTSE 100 ETF.

Market guarantor competition The more market makers compete to fulfill orders for a particular ETF, the narrower the bid-ask spreads when margins narrow.

High daily trading volumes Larger cash flows in and out of the more popular ETFs create greater opportunities for efficiency and competition among market makers.

You will notice that large ETFs that cover the most popular indices tend to have smaller spreads.

Highly liquid ETFs have very sharp spreads, while exotic specialty ETFs often have much larger profit margins. Spreads can be as low as 0.01 percent when ordering 10,000 SEK each S&P 500 ETFs. While the spread on a poorly traded ETF can be 1% for an order of 10,000 SEK or more.

This is important if you shop a lot because the spreads between buying and selling increase and subtract the performance of your portfolio just like any other cost.

The good news is that small investors are not penalized in the stock market. The electronic order book treats all market participants equally, and you are more likely to pay a lower difference for a small order than a giant institutional player would do in a huge order affecting the market.

How does ETF trading work?

In this post, you will learn about ETF price discovery and how to calculate the spread.

Important working hours

Another important tip is to properly timing your trades in international ETFs. ETF price discovery is most accurate when the market in which it is trading its underlying asset is open. For example, it is much easier to determine the Net Asset Value (NAV) of a Japanese stock ETF when Japanese markets are trading its component stocks for all to see. If the market is closed, the market maker will extend the bid spread over all ETFs that follow it. This is because they have to protect themselves from negative moves if their best “guess” about the price of Japanese stocks is wrong when the markets reopen. For a similar reason, it is best to trade commodity ETCs/ETFs when the US markets are open as the underlying assets are generally priced in US dollars.

It is best to trade ETFs that track Asian stocks in the early morning, while you have to wait until the late afternoon to trade ETFs against the US or Latin america.

ETF Liquidity Measurement

There is no single measure of liquidity but the spread is the most useful broker. Broad and efficient market ETFs that track the most popular indices will generally have narrow spreads. But it is worth noting the spreads of specialized ETFs such as:

• ETFs in Emerging Markets

• Smart Beta ETFer

• ETF sector

• Commodity ETFs

• High Return ETFs

• Thematic ETFs

Spreads vary each day according to market conditions, so it is a good idea to check the spread of your chosen ETF over a few days to assess its volume, especially against competing products.

The online broker or ETF provider must provide buy and sell prices on their websites. If there is little to choose from among ETFs, the most liquid over time will be the ones with the most assets under management (AUM), daily trading volume and market collateral.

Can I sell my ETFs at any time?

Spreads can increase during market turmoil, especially in niche markets. This is because market makers take greater risks when they buy ETFs from sellers and pass them on to new buyers. In a bear market, the wider bid-ask spread ensures that the market maker does not incur a significant loss if its ETF shares are bought at a lower price by the new buyer.

Market makers tend to enrich their margins at times like these, but ETFs will continue to trade as long as the underlying market remains liquid. During the Corona crisis, ETFs have proven to be tradable, although spreads have widened exponentially. As a buy and hold investor, you should avoid trading in such volatile times.

It’s impossible to predict how the ETF will track a less liquid market like high-yield corporate bonds in a crisis, so keep it limited to a relatively small share of total asset allocation if you’re running a portfolio strategy like Core-Satellite.

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