When exchange-traded funds (ETFs) originated, they were widely viewed as a more liquid alternative to mutual funds. Not only could investors gain the same broad diversification that they could with indexed mutual funds but, unlike mutual funds, they could also trade them during market hours. (To learn more about the differences between ETFs and mutual funds, and how to take full advantage, see Mutual Fund Or ETF: Which Is Right For You?)

More significantly, institutional investors could use them to quickly enter and exit positions, making them a valuable tool in situations where cash needed to be raised quickly. While individual investors have little recourse when liquidity decreases, institutional investors who use ETFs may avoid some liquidity issues through buying or selling creation units, which are baskets of the underlying shares which make up each ETF.

Lower levels of liquidity lead to greater bid-ask spreads, larger discrepancies between net asset value and the value of the underlying securities and a decreased ability to trade profitably. Let's look at which ETFs give you the most liquidity and therefore the most opportunity for profit. (For related reading, see ETFs: How Did We Live Without Them?)

Factors That Influence ETF Liquidity
It remains true that ETFs have greater liquidity than mutual funds. The degree of an ETF's liquidity depends on a combination of primary and secondary factors.

Primary factors include:

  • The composition of the ETF
  • The trading volume of the individual securities that make up the ETF

Secondary factors include:

  • The trading volume of the ETF itself
  • The investment environment

ETF Composition
ETFs can be invested in a number of asset classes including real estate, fixed income, equities, commodities and futures. Within the equity universe, most ETFs are invested in specific indexes, such as large-cap, mid-cap, small-cap, growth or value indexes. There also ETFs that focus on specific market sectors, such as technology, as well as certain countries or regions.

Generally, ETFs that invest in large-cap, domestically-traded companies are the most liquid. Specifically, several characteristics of the securities that make up an ETF will also impact its liquidity. The most prominent are explained below. (If you're an investor who likes to understand how and why your investment products work, check out An Inside Look At ETF Construction.)

  • Asset Class - ETFs that invest in less liquid securities, such as real estate, are less liquid than those that invest in more liquid assets, like equities or fixed income.
  • Market Capitalization - Market capitalization measures a security's value and is defined as the number of shares outstanding of a publicly-traded company multiplied by the market price per share. By default, the most well-known publicly traded companies are often large-cap stocks, which are by definition the most valuable of the publicly-traded stocks. ETFs that invest in equities are generally more liquid if the securities are well known and widely traded. Because these stocks are well known, they are commonly held in investors' portfolios and trading volume on them is high, which makes their liquidity high as well. Conversely, stocks of small and mid-cap companies are not as much in demand and are not as widely held in investment portfolios; therefore, trading volume and liquidity is lower for these stocks.
  • Risk Profile of the Underlying Securities - The less risky an asset is, the more liquid it will be. For example:
    • Large-cap stocks are considered less risky than small and mid-cap stocks.
    • Securities of companies in developed economies are considered less risky than those in emerging economies.
    • ETFs that invest in broad market indexes are less risky than those that focus on specific sectors.
    • In the fixed-income world, ETFs that invest in investment-grade corporate bonds and Treasury bonds are less risky than those that invest in lower-grade bonds.

As a result, ETFs that invest in large-cap stocks, developed economies, broad market indexes and investment-grade bonds will be more liquid than those that invest in their riskier counterparts.

  • Where the Securities In an ETF Are Domiciled - Domestic securities are more liquid than foreign securities for a number of reasons:
    • Foreign securities trade in different time zones.
    • Foreign exchanges, along with the countries in which they're based, have different trading laws and regulations, which affect liquidity.
    • Because most foreign equities are owned through American depositary receipts (ADRs), which are securities that invest in the securities of foreign companies rather than the actual foreign securities themselves, the liquidity of ETFs that invest in ADRs is lower than that of ETFs that don't. (Read more about ADRs in What Are Depositary Receipts?)

The size of the exchange in which the securities in an ETF trade also makes a difference. Securities that trade on large, well-known exchanges are more liquid than those trading on smaller exchanges, so ETFs that invest in those securities are also more liquid than those that don't.

Trading Volume of ETF Stocks
As market price affects a stock's liquidity, so does trading volume. Trading volume occurs as a direct result of supply and demand. In the financial world, lower-risk securities are more freely traded, and therefore have higher trading volume and liquidity. The more actively traded a particular security is, the more liquid it is; therefore, ETFs that invest in actively-traded securities will be more liquid than those that do not.

Individuals who invest in ETFs with fewer actively traded securities will be affected by a greater bid-ask spread, while institutional investors may elect to trade using creation units to minimize liquidity issues. (Despite their popularity, these funds have downsides that investors should consider. Learn more in Five ETFs Flaws You Shouldn't Overlook.)

Trading Volume of the ETF Itself
The trading volume of an ETF also has a minimal impact on its liquidity. ETFs that invest in stocks in the S&P 500, for instance, are frequently traded, which leads to slightly greater liquidity. (Not all these ETFs are created equal, however. Read S&P 500 ETFs: Market Weight Vs. Equal Weight to learn the differences and how they affect your portfolio.)

The Investment Environment
Because trading activity is a direct reflection of supply and demand for financial securities, the trading environment will also affect liquidity. For instance, if a particular market sector becomes sought after, ETFs that invest in that sector will be sought after, leading to temporary liquidity issues. Because the companies that issue ETFs have the ability to create additional ETFs fairly quickly, these liquidity issues are usually short term. (Why invest in sector ETFs? Read Singling Out Sector ETFs to find out.)

The Bottom Line
As with any financial security, not all ETFs have the same level of liquidity. An ETF's liquidity is affected by the securities it holds, the trading volume of the securities it holds, the trading volume of the ETF itself and finally, the investment environment. Being aware of how these factors affect an ETF's liquidity, and therefore its profitability, will improve results, which becomes especially important in environments where every basis point counts.

Related Articles
  1. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  2. Mutual Funds & ETFs

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  3. Investing Basics

    Top Tips for Diversifying with Exotic Currencies

    Is there an opportunity in exotic currencies right now, or are you safer sticking to the major ones?
  4. Mutual Funds & ETFs

    The 3 Biggest Mutual Fund Companies in the US

    Compare and contrast the rise of America's big three institutional asset managers: BlackRock Funds, The Vanguard Group and State Street Global Advisors.
  5. Investing Basics

    3 Alternative Investments the Ultra-Rich Usually Own

    Learn about the ultra rich and what normally comprises their net worth; understand the top three alternative investments usually owned by the ultra rich.
  6. Stock Analysis

    The 5 Best Dividend Stocks in the Healthcare Sector

    Learn about the top five dividend stocks of companies operating in the health care sector that generate substantial cash flows to afford high payouts.
  7. Investing

    Baby Boomer Philanthropy Shifts Wealth Adviser Focus

    Wealth advisers who integrate philanthropy and finance planning can stand out with baby boomer clients.
  8. Professionals

    5 Top-Rated Funds for Your Retirement Portfolio

    Mutual funds are a good choice for emotional investors. Here are five popular funds to consider.
  9. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  10. Chart Advisor

    Bumpy Roads Ahead In Transportation

    Investors are keeping an eye on the transportation industry. We'll take a look at the trend direction and how to trade it.
  1. What are the advantages of investing in ETFs with high trading volume?

    The advantages of investing in an exchange-traded fund (ETF) with high trading volume are increased liquidity, great parity ... Read Full Answer >>
  2. What are some of the most popular ETFs that track the Internet sector?

    While many tech investors are still leery of the Internet space since the great bust of 2000, others see an incredible new ... Read Full Answer >>
  3. Can mutual funds only hold stocks?

    There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
  4. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  5. Do mutual funds pay interest?

    Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
  6. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  2. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  3. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  4. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  6. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!