Exchange traded funds have experienced another record-breaking year of inflows, and as more advisors look to the popular investment vehicle, it’s important to understand how ETF liquidity works to ensure that clients are getting the most out of their ETF investments.
ETFs allow for portfolio flexibility and diversity through a convenient, tax-efficient method of investing in a variety of securities, including stocks and bonds. While ETFs trade on stock exchanges just as any other stock would, it’s important to look past just their daily trading volume when gauging their liquidity.
Liquidity is essentially how easy it is to convert an asset, in this case an ETF, into cash without affecting market price. ETFs are open-ended, meaning that individual units can be created or redeemed at any time by market makers in a primary market, based on investor demand. Because they contain an assortment of securities, how easy it is for the market maker to create or redeem depends on the liquidity of the securities the ETF contains.
It’s an important distinction to remember because the overall liquidity of an ETF is either enabled or limited by the liquidity of its underlying securities and is a different type of liquidity from trading volume. Investors affect the trading volume as they buy and sell in the secondary market, whereas the supply of the underlying securities or their ease/difficulty in trading directly impacts the creation and redemption mechanism done by market makers in the primary market.
This is easier to understand when you take an example of two ETFs that have the same basket of securities with the same or very similar weightings. Perhaps Fund A launched first and therefore has much great trading volume six months later, while Fund B, which launched shortly after, has a much lower average daily trading volume. You might be inclined to say that Fund A is more liquid because it’s trading more often and the spread on the bid-ask price might be smaller than Fund B, but in reality, they have the same liquidity since they carry the same, or very similar, highly liquid securities.
Understanding an ETF’s liquidity helps ensure that advisors and investors know what to look for when considering an ETF, and emphasizes that it’s important to understand what’s under the hood with this popular investment vehicle.
American Century Investments offers a broad range of transparent, actively managed ETFs from equities with funds such as the American Century Low Volatility ETF (LVOL) to bonds such as the American Century Multisector Income ETF (MUSI).
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