Part 3 | Liquidity
Liquidity is the ability to get in and out of an ETF. The more liquid an ETF, the easier, cheaper and faster it is. When choosing the right ETFs to buy, liquidity is, therefore, a key consideration. Below is a guide.
Liquidity is measured through buy-sell spreads (“slippage”)
When buying or selling any fund, there are costs of getting in and out. With managed funds, these are expressed as entry/exit fees. Managed fund providers charge investors these directly every time they take money out or put money in. The size of these fees are published on managed fund providers’ websites.
Source: Bloomberg, 25 May 2021
With ETFs, things work slightly differently. For ETFs, investors come in and out by trading on exchange. The liquidity of an ETF is measured through its buy-sell spreads – which is the gap between what an ETF is worth (it’s indicative net asset value, or iNAV, in the jargon) and the best price that someone is willing to buy or sell it for.
The bigger the spread – the less liquid an ETF is, and the more it costs investors to come and go. For this reason, the best ETFs to trade have tight bid-offer spreads. Investors can see the size of an ETF's spread by looking at an ETF on their brokerage platform.
Why some ETFs are more liquid than others
There are three main factors that determine how liquid an ETF is. Using our ETFS Physical Gold (ASX Code: GOLD) as an example:
The trading volumes of the ETF itself (i.e. how much GOLD trades on the ASX)
The trading volumes of their holdings (i.e. how much gold bullion is traded worldwide)
The trading volumes of similar things (i.e. gold futures, other gold ETFs)
April monthly trading data on the ASX. Source: ASX, 1 May 2021
Generally, the more an ETF, its holdings, or proxies are traded, the more liquid an ETF is. Thus, GOLD is one of the most liquid ETFs on the ASX because it is heavily traded by Australian investors ($105 million of GOLD traded hands in April 2021); the global gold market is massive, and there are lots of similar things that GOLD can be traded against (like futures).
When choosing an ETF, always look at its liquidity (spreads). But also, if possible, look to see how liquid an ETF’s holdings are. And how liquid alternatives might be.
ETFs stay liquid in a crisis
When markets get extremely volatile, all types of funds face liquidity challenges. Managed funds, for their part, can become gated or increase their exit costs. Listed investment companies and trusts (LICs and LITs) can trade on large discounts. In this way, it can be difficult or expensive for investors to leave managed funds and LICs when volatility rises.
As ETFs trade on exchange, they can never be gated in the way that managed funds are. Investors can always trade ETFs with each other on exchange. However, ETF spreads can, and do, widen in times of heightened volatility. A good example of this was during the coronavirus crisis of March 2020. During this time, some ETFs – especially those with illiquid holdings, like low-rated bonds, or small emerging markets companies – traded on very wide spreads. Whereas others with very liquid holdings and abundant proxies – like GOLD – remained on small spreads.
When choosing an ETF, investors should always try to form a picture of what the liquidity of an ETF might look like during market panics.