The Hidden Power of ETF Liquidity in Your Portfolio

There is no doubt the markets have been volatile this year. During such times, we believe it is important for investors to maintain a high level of liquidity. Compared to individual stocks or closed-end funds with fixed shares, ETF shares can typically be easily bought and sold at prices close to the NAV of the securities themselves, making them highly liquid. Investing in ETFs during periods of high volatility can therefore help to reduce certain types of risks for investors.

The VIX index is a forward-looking measure of market volatility that uses the price fluctuations of S&P 500 options as indicators of the expected market uncertainty over the next 30-day period (1). Between 1990 and 2020, the closing range on the VIX index fell between 9.14 and 82.69, with a higher VIX index indicating higher expected volatility (1). Not surprisingly, the VIX reached its highest levels in 2008 at the start of the Great Recession and again in 2020 with the beginning of the pandemic (1). In general, VIX values of 0 to 12 indicate low expected volatility; VIX values from 13 to 19 indicate normal volatility; and VIX values greater than 20 indicate higher than average volatility (2).

Volatility greatly impacts one’s ability to buy and sell stocks. An asset’s liquidity, therefore, refers to the ease with which it can be converted to cash without impacting its price (3). Cash is the most liquid asset while assets like real estate or rare coin collections are considered very illiquid. The ability to convert an asset to cash quickly in a highly volatile market can help to avoid forcibly selling at an unfavorable price. 

The bid-ask spread can be used to indicate an asset’s liquidity, calculated as the amount by which the asking price exceeds the bidding price (4). When a bid-ask spread is narrow, it means  the price a buyer offers per share is close to the price a seller is willing to accept. A tighter bid-ask spread indicates a more liquid market because not much value is sacrificed in exchange for a quick sale. The bid-ask spread can also be thought of as the difference between supply and demand.

Of course, bid-ask spreads vary by asset type. Equities are some of the most liquid assets on the market and ETFs are often just as liquid. US ETF trading volume has been increasing year over year for the past three years, representing as high as 26% of total US trading volume in 2021 (5). This increase is not just a reflection of natural market growth; ETF trading volumes are correlated with market volatility (5). As the VIX index increases above 30, which occurred on 15% of days over the past three years, the bid-ask spread of ETFs doubles, on average (5).

ETFs can offer highly liquid investment options for investors seeking to build low-liquidity risk portfolios for their clients.

  5. State Street Global Advisors SPDR (2022), The Liquidity Playbook: Trading ETFs in Volatile Markets, pp. 1-25.

It is important to consider trading volume and liquidity of underlying investments when evaluating the liquidity of ETFs.