ETF Liquidity: Drivers and Measurement

In the previous article, we understood what is ETF liquidity and why it is important for investors. We will continue to build on this and in this blog, we will learn about the ETF drivers and how we can measure ETF liquidity. This will help us in making informed decisions on ETF buying and selling.

Drivers of ETF Liquidity

Liquidity in ETFs is provided by market makers. The presence of active market makers is necessary to ensure adequate liquidity.

For an ETF, it depends on how profitable market making is. We discuss some important factors that drive the liquidity of ETFs:

• Liquidity of the underlying securities: ETFs that invest in underlying securities that are liquid and actively traded will be more liquid than ETFs that invest in illiquid securities. That is the primary reason that ETFs tracking large-cap indices have the highest liquidity. Bond ETFs and small-cap ETFs tend to have lower liquidity.

• Domicile of the underlying securities: If the underlying securities are domestic, the ETF will tend to be more liquid than an ETF that holds foreign securities, with everything else remaining the same.

• Presence of robust hedging instruments: Market makers hate directional risk and hence, the presence of low-cost hedging instruments (index futures) is important.

• Trading volume of the ETF: Trading volume is the number of shares/units traded during a specific period. The higher the trading volume of an ETF, the more liquid it tends to be. ETFs with high trading volumes have more market participants and are therefore easier to buy or sell.

How to Measure ETF Liquidity?

Till now, we have understood that liquidity is very important in ETF trading. But you must be wondering how you can measure liquidity. How would you know that an ETF has decent liquidity before buying it?

A good starting point is to look at the average bid-ask spread and average trading volume of that ETF. The bid-ask spread is the difference between the best buy and the best sell orders.

Also, when considering trading volumes, one should look at the average trading volume over the past month (or 3 months) to eliminate any transient spike in volume.

As a starting point, an ETF with a large trading volume is likely to be liquid. But the reverse may not be true. In the previous section, we noted that the trading volume of ETF is just one of the factors driving ETF liquidity. ETF liquidity is primarily driven by the presence of active market makers.

Sometimes, low-volume ETFs can have strong market depth due to the presence of active market makers making bids and asks. Also, if the ETF has active market makers, it is possible that your order (limit) gets executed even though it may not show up in the order book.

There is another source of liquidity which is directly buying and selling from the AMC. As noted earlier, this can only happen in predefined lot sizes (called creation units) and is therefore viable only for institutional and high net-worth investors. This facility of directly purchasing/redeeming from AMC for large investors is quite unique to India and is the direct result of a lack of liquidity in the secondary market.

In summary, there are a variety of ways to gauge the liquidity of ETFs. We discuss some general rules in this blog where we define a framework to find the most suitable ETFs for your portfolio.

In this article, we have discussed a key parameter that is widely used in ETF selection: Tracking Error. 

FAQs

Does low trading volume make ETFs illiquid?

Not necessarily. ETFs with low trading volume may still be liquid if they have tight bid-ask spreads and a sufficient number of market makers. 

What are the benefits of investing in ETFs with high liquidity?

Investing in highly liquid ETFs can provide investors with the ability to enter or exit a position quickly and efficiently, and at a fair price. It can also reduce the impact of transaction costs.