This article explores important aspects of ETF liquidity to reshape investors' understanding of trading and enhance their financial literacy.
Debunking Myths about ETF Liquidity
One of the most common mistakes investors make is relying solely on average daily trading volume (ADV) or total assets under management (AUM) to assess an ETF's liquidity. In fact, ETF liquidity is primarily determined by the liquidity of its underlying basket of securities. It is incorrect to assume that a small fund is necessarily illiquid, as a good underlying asset may indicate high liquidity, regardless of the fund's size.
Pitfalls and Risks of Complex ETFs
While the ETF arbitrage mechanism is generally robust, it can fail during periods of financial stress. Complex ETFs, such as leveraged and inverse funds, are intended for active trading but introduce additional risks such as 'volatility decay' and tracking errors. These mechanisms can lead to unexpected losses for long-term investors.
How to Access Deeper Liquidity for Large Trades
For executing large trades, there is an option to work directly with institutional trading desks to access the deeper liquidity of the primary market. This allows investors to avoid market impact costs and achieve more favorable execution prices compared to standard market orders.
Understanding true ETF liquidity and the mechanics of arbitrage enables investors to make more informed decisions and trade more effectively.
