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ETFs are traded on the exchange. This makes them a compelling alternative to Mutual Funds. Investors can buy/sell ETFs in real-time, unlike Mutual Funds where purchase and redemption can happen only at end-of-the-day NAV.
However, this ability to buy/sell comes at a cost. If the ETF is not liquid enough, you might pay much more than the market price when you buy the ETF. Similarly, you could receive much less than the market price when you sell the ETF. So, let’s understand the concept of liquidity in more detail:
In general, liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price.
So, for ETFs, liquidity refers to how quickly and easily you can buy or sell an ETF in the market. In simpler terms, it's how easy it is to turn your investment into cash. ETFs that have high liquidity tend to have a large number of buyers and sellers in the market, which means you can quickly buy or sell shares without affecting the market price.
On the other hand, ETFs that have low liquidity tend to have fewer buyers and sellers, which can make it difficult to buy or sell shares without affecting the market price. It's essential to understand that an ETF's liquidity can change over time, which is why it's important to keep an eye on the liquidity of the ETF you're interested in.
Now, let’s understand the importance of liquidity using a real case study.
Let’s assume that you want to diversify your portfolio and want to invest in gold using ETFs.
Let's assume you want to buy Rs. 10 lakh worth of gold for your portfolio.
Now, you decide to buy the gold ETF of Axis. Its price at the time of writing was around Rs.51.7. So you will have to buy 19340 units for your target allocation in gold. And you punch in a market order for this. From the below asks (see the image), we can say that your buying average will be around Rs. 51.9. This is 0.4% higher than your intended buying price. So, you are paying 0.4% just for purchasing the units from the market.
This is just the direct impact of a shallow order book. Now, let’s say you want to buy 50,000 units, you might move the price upwards and the impact on the final purchase price could be worse (market impact cost). Higher liquidity reduces the impact cost, which is the change in price caused by your trade. Low impact cost means you can trade an ETF without significantly affecting its price.
Liquidity matters. More so in the Indian context where a lot of ETFs are not very actively traded. In the next article, we will learn about the drivers of liquidity and how we can measure the liquidity of ETFs.
Factors that can impact ETF liquidity include market volatility, trading volume, investor sentiment, and the underlying assets' liquidity.
ETF liquidity can affect investors by impacting the cost and speed of trading an ETF, potentially resulting in higher transaction costs and lower returns. It can also impact the ability to exit a position quickly in times of market stress
The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for an ETF. A narrower bid-ask spread indicates higher liquidity