Many investment options are available based on the stock exchange. There are many mutual funds available for investors looking beyond direct equity. Mutual funds are not the best investment option for all investors. In such cases, an excellent alternative is to choose Exchange Traded Funds. ETF liquidity is considered more important than mutual fund liquidity in the general investor's perspective.
It is important to start with the basics in order to fully comprehend the details of ETF liquidity, and the risk associated with ETF liquidity. Before we answer the question "What is ETF liquidity?Let's take a look at ETFs in their actual form.
ETFs look a lot like mutual funds. They pool the financial resources from multiple investors to purchase various monetary assets such as shares, derivatives, bonds, and other securities. They look similar to mutual funds. ETFs are not managed actively, unlike mutual funds. ETFs can also be listed on stock exchanges, which is a difference from mutual funds. ETFs can be bought and sold easily on stock exchanges just like shares.
ETF liquidity is different from mutual fund liquidity. The liquidity of ETFs is more liquid. Let's dive into the details to better understand ETF liquidity.
ETF liquidity refers to the ease at which an Exchange Traded Fund (ETF), can be purchased or sold on the exchange. ETF liquidity can also be multi-layered because ETFs can be considered baskets of multiple assets. ETF liquidity generally has two components.
- The liquidity of ETFs traded on the Exchange
- The liquidity of individual assets within an ETF
The ETF's liquidity is generally determined by the liquidity of the assets that make it up. This makes it easier to redeem the ETF. This creates a direct link between the liquidity and liquidity of the ETF.
ETFs can trade in both the primary and secondary markets just like shares. In general, institutional investors can only trade in the primary market via Authorised Persons. These investors have deep pockets and trade in thousands of units at once. These heavy-duty transactions can have an impact on the supply of ETFs in secondary markets, as institutional investors either purchase or redeem large amounts of assets via ETFs.
Non-institutional investors and retail investors trade mainly through secondary markets. This is similar to how shares can be bought or sold. ETF liquidity can be affected by many factors in both the primary and secondary markets.
The liquidity of ETFs is influenced by four main factors.
1. How the ETF is made
2. The ETF's trading volume
3. Trading volume of the ETF
4. The overall investment ecosystem
Let's take a closer look at each one.
ETFs can invest in multiple asset types. For example, equity ETFs may duplicate specific indices such as large-cap, smallcap or growth. ETFs that focus on specific market sectors, such as IT or real estate, may also be available. ETF liquidity is affected by the general liquidity of the assets comprising them.
This holds true for ETF liquidity risk. Liquidity is a function of how low an asset's investment risk. This reduces ETF liquidity risk overall, as it is much easier to sell or buy such funds.
Supply and demand factors influence trading volume. Trades are simpler for low risk securities because they are in greater demand. This can often translate to high trading volumes. ETFs with high trading volumes will have higher overall liquidity.
The trading volume of constituent assets is not the only factor. However, the ETF has its own trading volume. This is affected by the overall category of assets in the ETF basket. Large-cap ETFs, for example, may be traded more often than smaller-cap ETFs. This means that the liquidity of the latter is lower than that of the former.
ETF liquidity may be temporarily affected by the overall market sentiment, trends in the sectors that are associated with the ETF and the general economic state. It's a smart idea to consider all these factors when considering investing in Exchange Traded Funds.
ETFs can be a liquid asset, but not all ETFs have the same liquidity. Some ETFs are more liquid than others. Before including a fund in their portfolio, investors should consider all factors that influence its liquidity.