What is ETF liquidity?

 

A popular financial product with increasing demand is an Exchange Traded Fund (ETF). An ETF has a fund of tradable assets such as stocks and bonds.

 

For example, one can invest in the Dow Jones Industrial Average through investing in an exchange-traded fund that tracks the DJIA and others like it.

 

An ETF’s performance does not depend on any specific company within its portfolio. Instead, they are “market-weighted” so that price changes in any individual stock will affect an ETF’s return to a lesser or greater degree than its market benchmark index.

 

Some of the most extensive ETFs track indices such as the S&P 500 index, whose growth depends on their underlying companies’ success since various companies are responsible for different percentages of the S&P 500.

ETF diversity

ETFs provide diversity and low-cost trading as they are bought and sold through a stock exchange, just like shares of stock. ETFs have lower management fees than most mutual funds because they don’t require active managers to choose which stocks to buy and sell or portfolio rebalancing, as is required with actively managed mutual fund portfolios

 

Unlike typical open-end mutual funds, an ETF is traded on a stock exchange throughout the day at whatever price it commands. In contrast, an open-end fund trades only once per day after the market closes at NAV (net asset value).

 

If there were no demand for an ETF during the trading day, its share price would be bid down to whatever price is necessary to find a single buyer and seller, called the “intraday market value”. It might be much less than its NAV if it has a small number of shares outstanding.

Advantages

A vital attribute of an ETF’s ability to track its benchmark index is that they have little or no investment risk due to their low expense ratios, which allow better returns than traditional mutual funds while minimizing downside risk.

 

Reuters Money’s additional demand for lower-cost index ETFs resulted in $7 billion in new assets in August 2013 alone.

 

ETFs offer diversity by investing across sectors, geographies, asset classes and styles, so one may choose ETFs based on their desired level of risk and return.

 

ETFs gained significant popularity in the late 1990s as a result of several positive developments: Index investing became more popular with investors interested in index funds “passive management”; ETFs provided a low-cost way to track an index; and ETFs evolved from being single stock issues into multi-asset portfolios making it easier for asset allocators to diversify risk by allocating across different asset classes such as stocks, bonds, commodities and currencies.

 

In addition, the 1990s also saw an explosion in the number of individual investors through day trading and other forms of the technical analysis made possible by electronic trading platforms.

 

Professionals who manage other peoples’ money were drawn to ETFs because they are easy to trade, increasing market liquidity and lowering the bid/ask spread, making it easier for advisors and individual investors to trade.

 

ETFs offer intraday market pricing, tax efficiency and the ability to issue baskets of stocks that may be difficult to replicate, which is essential in high growth emerging markets such as China and India.

 

Moreover, most ETFs are passively managed index funds tracking an index consisting of a basket of securities.

 

They do not attempt to “beat” the market by selecting winning stocks or buy when prices are low or sell when prices go higher as active mutual funds do at their own expense (see more under Expense Ratio ).

 

It has made them popular with long-term buy-and-hold investors who want lower fees and better returns than traditional actively managed mutual fund portfolios.

Disadvantages

However, ETFs are not without their critics. Some express concern about the lack of transparency in the number of shares issued and outstanding, which makes it challenging to determine what is driving prices up or down and for how long an ETF can remain liquid when share issues are large.

 

Some claim that there has been a corresponding increase in volatility with the increased use of ETFs. Others argue that index-tracking funds reduce diversity by causing investors to “clump” into only a handful of indexes with the same asset class composition.

 

There have also been incidents where poorly managed ETFs were forced to be liquidated in the middle of trading at NAV revealing flaws with the current market structure.