Posted by Gary Abely, CPA, CFP®, AIF®
Exchange Traded Funds (ETFs) have become popular for their low cost and tax efficiency, but are they liquid and appropriate for your portfolio? As we enter the lower trading volume and often more volatile period of the summer months, it is an important question to ask yourself, especially if you utilize stop loss orders (explained later).
Exchange traded funds typically invest in a basket of stocks and can be traded during stock market trading hours of 9:30 a.m. to 4:00 p.m. In contrast, mutual funds sold during this time period receive the Net Asset Value (NAV) of the underlying holdings at 4:00 p.m., in other words ending day valuation. Many investment advisors feel that because ETFs can be sold throughout the day, they are more liquid.
To answer the question whether or not a particular ETF is liquid, we have to understand the definition. A liquid investment is one where the owner has immediate or fast access to buy, sell and withdraw funds. Further, a liquid asset is one which can be converted to cash readily at minimal price impact. Our U.S. stock market is typically viewed as a liquid market because there are many buyers and sellers. Due to high volume of electronic trading between parties, equity (stock) investments may be sold quickly and converted to cash, usually with minimal price impact. So, under most market scenarios one would say ETFs are in fact liquid. But, to give a more complete answer, one has to look at the liquidity of all of the underlying securities contained in the ETF. For example, if an ETF contains small companies invested abroad with little trading volume, this security would likely not be liquid. In other words, an ETF is only as liquid as the liquidity of the underlying investments.
Many investors who purchase individual stocks and ETFs prefer to implement a strategy known as a stop loss order. A stop loss order is a contingent order to sell (and stop the loss) if an investment drops a certain percentage, say 20% in value. Recent history has shown us examples where ETFs invested in large U.S. companies dropped in value significantly below the underlying value of their investments. In fact, many investors who had placed stop loss orders were liquidated of their ETF investments at losses exceeding 30%, despite ending day valuations that were well within 5% of opening valuation. It is important to remember that any individual security can have supply and demand imbalances due to company news, world headlines, or even technical market glitches such as imbalanced order flow.
In summary, while many ETFs offer advantages of low cost and tax efficiency and may well be appropriate for your portfolio, don’t make the assumption these investments are liquid under all market scenarios. In addition, be careful when utilizing stop loss orders for ETFs. When everyone rushes for the exit door, will your ETF be liquid?