How do ETFs increase liquidity?
Short sellers provide liquidity, as they tend to be selling into demand when share prices appreciate, and conversely looking to buy back shares when prices decline. For example, if most investors are optimistic about the asset's future performance, ETF share prices increase, leading to more demand of ETF shares.
ETF liquidity has two components – the volume of units traded on an exchange and the liquidity of the individual securities in the ETF's portfolio. ETFs are open-ended, meaning units can be created or redeemed based on investor demand. This process is managed by market makers who buy and sell ETFs throughout the day.
Mutual funds and ETFs may hold stocks, bonds, or commodities. Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.
As a result, trading activity in the underlying securities is linked through common ETF ownership, leading to simultaneous trading in these securities. This in turn, is associated with correlated demand for the liquidity of these securities, and therefore, greater commonality in liquidity between them.
Once the decision to delist or liquidate an ETF has been made, a prospectus supplement will state the ETF's last trading date and its liquidation date (if it has one). At this point, or soon after, “business as usual” ceases, and the fund halts creations as it prepares to convert to cash.
iShares iBoxx $ High Yield Corporate Bond ETF is the largest and most liquid fund in the high-yield bond space, with AUM of $19 billion and an expense ratio of 0.49%. It offers exposure to a broad range of U.S. high-yield corporate bonds.
The price of an ETF may deviate from the NAV of the ETF due to changes in the supply or demand for an ETF at any single point in time. The market price will typically exceed the NAV if the fund is in high demand with low supply. The NAV will generally be higher if the fund has a high supply with little demand.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
ETFs have differing liquidity profiles for many reasons. Investing in an ETF with relatively low liquidity may cost you in terms of a wider bid-ask spread, reduced opportunity to trade profitably, and—in extreme cases—an inability to withdraw funds in certain situations like a big market crash.
The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.
Why is ETF liquidity important?
The goal of this often-used metric is to provide a baseline of how many ETF shares can be traded through the underlying basket before impacting the price of the least-liquid security in the basket. Many ETF data sites provide the implied liquidity metric for funds with equity-based underlying securities.
Exchange-traded funds work like this: The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don't own the underlying assets in the fund.
Unlike index mutual funds, ETFs are flexible investment vehicles that are highly liquid. They can be bought and sold on a stock exchange throughout the trading day, just like individual stocks.
For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.
Key Takeaways. Investors looking to weather a recession can use exchange-traded funds (ETFs) as one way to reduce risk through diversification. ETFs that specialize in consumer staples and non-cyclicals outperformed the broader market during the Great Recession and are likely to persevere in future downturns.
ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.
There are three levels of liquidity to consider for ETFs: on-screen liquidity, broker-assisted liquidity and specialist-accessed liquidity.
In contrast, the riskiest ETF in the Morningstar database, ProShares Ultra VIX Short-term Futures Fund (UVXY), has a three-year standard deviation of 132.9. The fund, of course, doesn't invest in stocks. It invests in volatility itself, as measured by the so-called Fear Index: The short-term CBOE VIX index.
| Symbol | Vol * Price | Price |
|---|---|---|
| QQQ D | 20.66 B USD | 426.51 USD |
| IWM D | 5.692 B USD | 197.68 USD |
| TLT D | 4.33 B USD | 88.40 USD |
| TQQQ D | 3.875 B USD | 53.71 USD |
Remember that, to assess secondary market liquidity, you should be looking at statistics such as average spreads, average trading volume, and premiums or discounts (does the ETF trade close to its net asset value?).
Should you put all your money in ETFs?
You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.
The Cost of Leverage
Leveraged ETFs use various financial instruments such as futures, options and swaps to achieve their leverage. These instruments have associated costs, including transaction costs, bid/ask spreads and management fees. These costs can eat into the returns of the ETF and contribute to its decay.
ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.
If Vanguard ever did go bankrupt, the funds would not be affected and would simply hire another firm to provide these services.
The price of an ETF share generally stays very close to NAV but if the share price is below the NAV, then the ETF is said to be trading at a discount. Conversely, if the ETF share price is more expensive than NAV, the ETF is said to be trading at a premium.
