The Dynamics Of Liquidity And Investing

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.

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