The Dynamics Of Liquidity And Investing

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December 15, 2015 4:36pm NYSE:HYG NYSE:JNK

money and investingBlackRock’s Matt Tucker explains the concept of liquidity and sheds some light on the dynamics of liquidity and exchange traded funds.

bambara / Shutterstock

bambara / Shutterstock

I’ve been getting questions recently about liquidity, specifically in the context of exchange traded funds (ETFs). Liquidity is a hot topic in financial markets these days, so let’s spend a little time going over it. First, we’ll explore what we mean by “liquidity” and then we’ll explain what it means when it comes to ETFs.

Defining liquidity

When I think about liquidity, I think about a transaction: I am able to buy or sell something at a known price. The more liquid an investment, the easier it is to buy and sell without affecting the asset’s price. More fully, liquidity has three main components: price, time and size.

If an asset is liquid, I can trade it quickly, and I can trade a large amount of it, without moving its price. In reality, most investments involve trade-offs between these three components.

Want to trade quickly? You may not be able to trade a large amount, or you may impact the price you are going to receive. Want to trade a large amount? Do it slowly, or be prepared to impact prices. A general rule of thumb for liquidity for most investments is that you can get two of the three attributes, but not all three at once.

If we consider liquid assets, a large cap stock is a good example. Unless you are trading a significant number of shares, you can generally trade fairly quickly at a price that is close to what you see on the exchange.

A home, on the other hand, is relatively illiquid; you can get an estimate on its price, but until a buyer signs on the dotted line and you have a check in hand, it’s unclear what you’ll actually get when selling your home. And it will generally take you a while to sell your home, no matter what its size.

Liquidity and ETFs

When it comes to a security like an ETF, I can see that it’s trading at a certain price, and I can generally buy or sell that ETF at a price that’s pretty close to the quoted price. I can generally trade fairly quickly, as long as my trade is not large compared to the security’s volume. A large ETF trade is in some ways similar to a large equity trade; I need to trade over time or risk impacting the price.

Let’s take it a step further and look at bond ETFs. If you want to go out and buy a bond, you can’t just buy it on the open market via an exchange. Instead you would buy it over the counter, in a negotiated transaction with a broker.

The price you would trade at is often unclear, and it can be difficult to trade a large amount, or trade quickly. In fact, some investors may find that individual bonds don’t have any of the three aforementioned features of liquidity.

With a bond ETF, which is a basket of bonds traded on an exchange, you have much more price transparency. You can actually see the price at which a bond ETF is trading and have a sense of the price of a trade and how many shares might be available to trade at that price. As the bond ETF trades on an exchange, you can generally trade it with the same speed as an individual stock.

The liquidity rule of thumb still applies to bond ETFs; it can be difficult to trade in large size, quickly and without impacting price, but overall, exchange trading liquidity can be greater than liquidity in underlying markets.

And that is an improvement that all investors can benefit from.

What are your questions about ETFs and liquidity? Ask them here.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to the The Blog.

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