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Why ETF liquidity matters

As a long-time investor, exchange-traded funds (ETFs) have become an increasingly important part of my portfolio. While we consider many attributes when choosing ETFs – such as cost, diversification and tracking index performance – one factor that sometimes gets overlooked is liquidity. Liquidity refers to how easily an asset can be converted into cash without affecting its market price.

For ETFs, liquidity measures the wide bid-ask spread in the secondary market and how many shares can be bought or sold each day before impacting the share price. Strong liquidity allows investors to get in and out of positions when needed. This article will discuss why ETF liquidity matters more than many realise. Knowing how liquid an ETF is can make a big difference, especially during market volatility.

Understanding ETF liquidity

ETFs are traded on a stock exchange, which means that they can be bought and sold throughout the trading day. It is in contrast to traditional mutual funds that are priced at the end of each day. ETF liquidity is determined by its underlying assets – typically stocks or bonds – and market demand for those shares. An ETF with high liquidity will have many buyers and sellers in the market, making it easier to execute trades without significant price impact.

On the other hand, ETFs with low liquidity may have a wider bid-ask spread and fewer buyers and sellers, meaning that investors could end up paying more or receiving less than expected when buying or selling shares. In extreme cases of illiquidity, investors may even need help finding a buyer for their shares, leaving them stuck with the investment. Saxo Dubai Markets can provide more information on ETF liquidity.

Assessing liquidity risk

One way to assess liquidity risk is by looking at the average daily trading volume. It measures the number of shares traded in a day and can provide an indication of how much liquidity an ETF has. Generally, a higher trading volume means more buyers and sellers in the market, increasing liquidity.

Another measure to consider is the bid-ask spread. The bid price refers to the highest price buyers are willing to pay for a share, while the ask price is the lowest price sellers are willing to accept. The difference between these two prices is known as the spread and can vary by ETF depending on liquidity. In general, a smaller bid-ask spread indicates higher liquidity.

Downside of liquidity issues

Investing in an ETF with low liquidity can have negative consequences for investors. For one, it could mean that the investor may be unable to sell their shares when needed, leaving them stuck with an investment they no longer want. In such cases, investors may be forced to sell at a discount or hold onto their shares until the market improves.

Furthermore, illiquid ETFs are more susceptible to price volatility, as even a small trade can significantly impact the share price. It means that investors could pay more for shares or receive less when selling them.

Considerations for Portfolio Construction

When constructing a well-diversified investment portfolio, it is essential to consider the liquidity of ETFs carefully. Liquidity is the ease of buying or selling an investment without causing significant price changes. A mix of liquid and illiquid ETFs can provide investors with a balanced approach, considering potential returns and risk.

Liquid ETFs have high trading volumes and tight bid-ask spreads and are suitable for short-term trading strategies. They allow investors to enter or exit positions quickly, capitalising on market opportunities. On the other hand, less liquid ETFs, with lower trading volumes and broader spreads, may be more appropriate for long-term investments. These ETFs track niche markets or asset classes that are less frequently traded.

In addition to considering individual ETF liquidity, investors should also evaluate the overall liquidity of their portfolio. Holding too many illiquid investments can create challenges if funds are needed unexpectedly or if there is a change in investment strategy. Maintaining a balance between liquid and illiquid investments can help mitigate potential liquidity risks and ensure the portfolio remains flexible.

Enhancing liquidity preparedness

To prepare for potential liquidity issues, investors should regularly review their portfolio holdings and assess the liquidity of each ETF. It means considering factors such as trading volume, bid-ask spread and underlying assets. Investors should also stay informed about market trends and changes that could impact an ETF’s liquidity.

Furthermore, diversifying investments among different asset classes can add another layer of protection against liquidity risks. It can include holding a mix of ETFs, stocks, bonds and other assets in a portfolio. Finally, investors should have a plan for unexpected situations that could impact their investments. It could involve setting aside emergency funds or having alternative sources of income to cover expenses in case of market volatility.

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