However, an ETF is not an individual stock or share, but instead an investment fund that only requires liquid underlying assets to be liquid at the fund level.
Therefore, ETF liquidity needs to be looked at differently to traditional stocks or shares liquidity.
In our example, having zero ETF shares traded for even a year has no impact on the ETF being able to trade $50m (£38m) in a single day. This is because the investment manager of the ETF can invest $50m dollars into the FTSE 100 companies with no issues.
Therefore, all it exhibits is investor demand in that particular ETF, not its level of liquidity.
Even if we look at a more illiquid underlying asset, for example junk bonds, the story is the same. In normal circumstances, a popular junk bond ETF may have significant volume on exchange as investors buy and sell the ETF throughout the day.
In more extreme market conditions where investors all sell at the same time, the underlying bond liquidity is tested, but again, the exchange volume of the ETF itself is not a relevant indicator of liquidity.
The investment manager needs to sell the underlying junk bonds to other buyers who may be few and far between. This is the relevant aspect of the ETF’s liquidity profile.
Does size matter?
A common misconception around ETFs is that those with lower assets under management are less liquid.
This is not necessarily true, and again, what typically matters most are the underlying constituents that need to be traded when the ETF is bought or sold.
The other ETF size consideration is whether the ETF has sufficient assets to effectively hold and therefore track the underlying constituents of the index.
For example, if an ETF tracks a corporate bond index with 1,000 bonds, it may not be able to do that effectively with $1m.
But this is a separate point to liquidity.
If we take a FTSE 100 ETF that has $1m in total AUM, an investor might be wary of investing for liquidity reasons. However, an investor can very comfortably invest $50m in a day bringing the total assets to $51m, due to the liquidity of the underlying FTSE 100 companies.
All that has happened is that the investment manager has bought $50m of the underlying companies in the index and they can redeem them the next day if they wish, with zero effect on the functionality of the ETF.
The liquidity of ETFs has long been misunderstood and, sometimes, misrepresented. It is the underlying assets that determine true liquidity, not the structure of a fund.
Anthony Martin is a co-founder at Rize ETF
