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Understanding ETF Liquidity


ETFs may seem like simple investment products because of their indexed approach. However, because ETFs combine features of mutual funds and individual stocks, their complex inner workings take some time to understand.

Even some financial advisors need to brush up on ETF education, especially when it comes to the funds’ liquidity.

“ETF sponsors view misconceptions surrounding liquidity as the top growth challenge in 2013 as nearly two-thirds (63%) rated it as such,” Alec Papazian, associate director at Cerulli Associates, said in a Financial Planning article. “Liquidity and trading ranked the lowest, suggesting these two topics should remain top of mind for providers when developing educational program.”

According to Cerulli, unfamiliarity with ETF liquidity could unnecessarily cause many advisors to gloss over ETF trades. [ETF Liquidity: Look Beyond Trading Volume]

“There still is quite a misconception that looking at the trading volume of an ETF tells you if it’s liquid or not-the composition of the ETF, the trading volume of the individual securities that make up the ETF, the trading volume of the ETF itself, and the investment environment are also important factors,” Papazian added.

However, a lot of advisors are content with big ticket ETFs, so many simply do not even register ETF liquidity issues.

“Liquidity is not a big issue for me,” George Papadopoulos, a registered financial advisor, said in the article. “I tend to use just broad-based ETFs, such as total stock market, the S&P 500 and the Russell 2000. I don’t go to bed thinking if the Vanguard ETF I invested in yesterday will be liquid tomorrow. I sleep soundly.”

Papadopoulos, though, believes that understanding ETF liquidity is more important for advisors that are using ETFs as a tactical, short-term allocation.

With the ETF industry continuing to expand – the industry grew 27.3% in 2012 on record inflows of $184 billion, ETFs, along with all their quirks, will be too big to ignore. Cerulli estimates that advisors have about 7.1% allocated into ETFs and expects the number to rise to 7.8% in 2013, driven by low fees and growing popularity for passive investments.

“There’s no doubt that ETFs are growing in adoption and popularity, so to offer clients the right advice, financial advisors would be wise to educate themselves on all aspects of ETFs-liquidity and all,” Sean Walters, chief executive officer of the non-profit Investment Management Consultants Association, said.

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.