ETFs are highly liquid. How do they do it?

We often describe our exchange traded funds (ETFs) as “highly liquid”. And they are. Compared to many investments, ETF investors have great freedom to buy and sell at a market rate, and to have the exchange completed rapidly. In this edition of Inside Track, we take a moment to explain the mechanics that make this possible. 

First, it is useful to highlight the very opposite of a liquid asset. Houses, pensions, art and jewelry would all be considered highly illiquid. Turning these assets into cash takes time, risk and effort. It attracts high transaction costs. Working out a good price is difficult, too. ETFs differ from these in important ways. 

One way ETFs differ from these illiquid assets is that they trade on a stock exchange – in our case, the Johannesburg Stock Exchange (JSE). Just like any company share, an ETF follows a legislated process to become a tradable asset. The difference between a company share and an ETF is simply that the ETF functions as a wrapper that holds several assets – including shares, government bonds and even cash. 

The result is that ETFs are bought and sold whenever markets are open. That means individual DIY investors can go online and make an offer to sell ETFs at a given price or make a bid to buy ETFs at a given price. 

This is where the second important differentiator comes in: market makers. These are institutions that hold substantial amounts of cash and a large number of ETFs, and help to create an efficient market by buying and selling ETFs. 

Market makers have the technology and systems to pick up on offers to sell and bids to buy – just like those you put into your trading platform or like a large financial services company may do at scale. The market maker assesses these bids and offers, and then buys and sells accordingly, based on their evaluation of how attractive the prices are. 

Of course, ETFs aren’t speculative assets that are expected to display large price swings in short periods of time. So the bids and offers tend to be very close to the quoted prices on the JSE. Market makers are sophisticated investors who trade on these small margins. 

The result is that, while selling your house may take weeks, months or even years, holders of ETFs have great confidence that they can sell their ETFs rapidly at the price quoted live on the stock exchange, or at a price that’s very close to it.

Regards,

The 1nvest team