What is ETF implied liquidity
Many investors are willing to invest in exchange-traded funds (ETF); however, lack of knowledge about various aspects of the ETF trading is restricting them from making any move. One of the most common thing that most people do not know about, is the liquidity issue. Many of the ETFs are thinly-traded and have lower assets under management (AUM). This sends a signal to investors that the liquidity in the ETF is not sufficient to trade and, hence, better to remain away from such ETFs.
Nevertheless, the core liquidity of an exchange-traded fund (ETF) is based upon the underlying basket, which the ETF represents. For example, Edelweiss ETF - Nifty 50, which is based on Nifty 50 and is benchmarked to Nifty 50-TRI, has an AUM of mere Rs. 1.1 crores at the end of October 2019. In the last one month ended November 13, 2019, the average trading volume of the ETF was at 7.6 and the total trading volume was merely 114 in the entire month. If we compare these parameters with trading in shares, it might indicate that they have lower liquidity and, hence, cannot be traded easily. Even if you want to trade you will have to bear a higher impact cost.
You can buy the actual ETF in the market or you can buy the exact basket, underlying the ETF, and convert it into ETF shares via the creation redemption mechanism. This is probably one of the most important concepts in understanding how an ETF works and it underpins the trading differences from stocks. The discussion around trading volume and potential liquidity have hamstrung many clients.
ETF trading volume is not equal to ETF liquidity. This is a critical concept to understand when looking at ETFs, perhaps one of the most critical considerations when assessing your investment amount. ETF volume is a historical number that shows what has traded in the past. ETF-implied liquidity is a forward-looking number that gives an idea of how much of an ETF can be traded in the future. It can be assessed by taking the average daily volume of an ETF itself as a benchmark or how many ETF shares can be traded without a bigger impact cost. In addition to this, what determines the liquidity of ETF, are the liquidity of underlying securities, derivatives based on the ETF, and correlated, but different, trading vehicles.
Therefore, you need to understand that liquidity of an ETF is a function of a much greater group of variables than just the historical trading volume.