Trading volume is the total number of ETF units bought or sold during the trading hours on a given day whereas liquidity is the ease with which the units of an ETF can be bought and sold on the exchange.
While trading volume affects the liquidity, it is not the only factor that affects liquidity. Let’s take a look at the other factors affecting liquidity
1) Composition of the ETF
If the underlying stocks of the ETF are highly traded, the ETF will be more liquid as well. ETFs that invest in large cap stocks may be more liquid as compared to ETFs that invest in small or mid cap stocks. This is because large cap stocks are usually more widely traded than small cap or mid cap stocks hence the trading volume on large cap stocks is higher making it more liquid.
The asset class also causes an impact on the liquidity of the ETF, as trading volume increases or decreases based on what is most preferred by investors, e.g., ETFs that invest in real estate may be less liquid than ETFs investing in equities.
2) Market Conditions
The liquidity of ETFs may also depend on the overall market conditions. Periods of high market volatility or economic uncertainty may cause liquidity issues if a lot of people are trying to buy or sell their investments at the same time.
3) Sector Performance
If a certain sector is performing well, ETFs tracking that sector may see increased trading activity. This increased trading activity can improve liquidity for those specific ETFs as there is greater participation from buyers and sellers where as if investors are rapidly moving away from a sector, the ETFs tracking that sector may experience decreased liquidity.
It also helps the investors zero down on a particular ETF for investment that aligns with their goals.
4) Trading Volume
Last but not the least, trading volume
impacts the liquidity of the ETF as well. Frequently traded ETFs have a higher trading volume and vice versa.
The factors listed above may also affect the trading volume of the ETF.
Therefore, we know that trading volume is not the sole reason that affects the liquidity of an ETF. ETFs with a lower trading volume can still be liquid if their underlying securities have a high level of liquidity.
Thus, the liquidity of ETFs does not depend solely on its trading volume but is also affected by other factors.
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