Exchange-Traded Funds (ETFs) have recently been considered to be one of the most popular investment methods for investors. What makes it attractive, lies in the low cost to enter, the diversity available, as well as the ability to be traded just like regular stocks during the 5 days a week trading hours. However, while ETFs may appear simple, an important factor that traders or investors often overlook is the liquidity risk, and to understand this concept is most vital to making the best decisions and avoiding the unwritten risks.

What Is Liquidity Risk?

Liquidity risk indicates a possible difficulty of buying or selling an ETF without significantly impacting its price. To simplify, it’s the risk that you may not be able to enter or exit a trade at a fair price. For ETFs, with liquidity risk there are two levels:

  • Primary Market Liquidity – The ability of Authorized Participants (APs) to create or redeem ETF shares by trading in South Africa the underlying securities. This ensures that ETF prices generally track their Net Asset Value (NAV).
  • Secondary Market Liquidity – The trading activity of ETF shares on an exchange. Here, liquidity is measured by bid-ask spreads, trading volumes, and market depth.

Why Liquidity Matters for ETF Investors

  • Trading Costs:  A larger bid-ask spread increases your cost of transaction, specifically for the larger trades made.
  • Price Deviations: When market conditions are stressful, ETFs tend to trade at a premium or discount to the NAV (Net Asset Value), this exposes the trader to more risk.
  • Market Access: ETFs that hold the illiquid securities (such as high-yield bonds or emerging market stocks) tend to be harder to trade efficiently, this happens, even if the ETF itself is listed on a liquid exchange.

Factors That Influence ETF Liquidity

  1. Underlying Asset Liquidity
    An ETF which tracks the S&P 500 will tend to be highly liquid, why? Because the underlying stocks are frequently traded. On the other hand, an ETF which invests in frontier markets or thinly traded corporate bonds may face higher liquidity risk.
  2. Trading Volume
    A  trading day in which there is high trading volumes would typically indicate better liquidity and a smaller bid-ask spread.
  3. ETF Structure
    The role of APs in creating and redeeming shares helps maintain the liquidity, but like before, during periods of stress, even APs may face difficulty sourcing or delivering the underlying assets.
  4. Market Conditions
    Liquidity risk would often spike during market downturns or periods where markets are volatile, when investor demand for liquidity surges but underlying asset liquidity dries up.

How to Assess ETF Liquidity Risk

  • Check Bid-Ask Spreads: smaller spreads = Better liquidity.
  • Look at Average Daily Volume (ADV): Higher volume provides more trading flexibility.
  • Monitor Premiums/Discounts: Constant market movements away from NAV may signal liquidity concerns.
  • Understand the Underlying Market: If the ETF typically invests in illiquid assets, liquidity risk would remain, regardless of its trading activity on the exchange.

Common Mistakes Investors Make in ETFs

  1. Equating Trading Volume with Liquidity
    High ETF volume does not equal low liquidity risk, if the underlying assets are illiquid.
  2. Overlooking Stress Scenarios
    Investors would often dismiss how ETF types behave during market turmoil, when liquidity risk becomes most visible.
  3. Assuming All ETFs Are the Same
    Equity index ETFs are generally safer from a liquidity standpoint compared to bond ETFs or niche thematic ETFs.

Conclusion

Liquidity is a typically hidden but most important dimension of ETF investing. While ETFs do offer the flexibility in options, generally a low cost, investors must always stay vigilant that the liquidity can depend majorly on the underlying assets, market conditions, and ETF structure. By keeping the bid-ask spreads in mind, as well as trading volumes and also NAV premiums or discounts in mind, ETF beginner traders in South Africa and long-term investors can be much better at developing ETF effective strategies to manage liquidity risk and avoid unexpected surprises.

Explore ETFs Investment in South Africa now