Illiquidity Concerns May Be Unnecessary With Smaller ETFs

Advisors interested in incorporating new ESG and other specialty ETF strategies into their clients’ portfolios may have concerns about the size of the fund and its potential illiquidity. ESG and specialty funds like thematic ETFs can often have smaller amounts of assets under management, especially when they are new. However, these concerns may be unfounded. A fund’s size should not necessarily hinder achieving the desired exposure.

In this article, we will explore why advisors may not need to worry about illiquidity regarding ESG and other specialty ETFs. We will also offer some tips on how to mitigate any potential issues.

Liquidity of New ETFs

First and foremost, it’s important to understand that ETFs, in general, have a liquidity advantage over other types of vehicles. As Todd Rosenbluth, head of research at VettaFi, explains, “The true liquidity of an ETF is the holdings inside. An ETF that invests in large-cap securities is more accessible than the ETF’s average daily volume. New shares can easily be created, but advisors must work with their block desk for best execution.”

First of all, ETFs are generally more liquid than many other investment vehicles, regardless of their size. This is because ETFs are intentionally designed to be as liquid as their underlying holdings. For instance, if an ESG ETF invests in large-cap securities, which are generally more liquid, then the fund is likely to be highly liquid despite the fund’s average daily volume. Similarly, many thematic ETFs hold large allocations to FAANG stocks and other large-cap tech stocks. These ETFs may have higher liquidity based on their holdings, even with only a few million in assets. ETFs also benefit from a robust ecosystem that supports their accessibility. They have authorized participants and market makers who are instrumental in maintaining liquidity. They do this by creating and redeeming shares as needed, which helps keep spreads tight. It’s important to remember that ETFs are not traditional mutual funds and utilize distinct mechanisms to manage liquidity.

Potential liquidity risks may still exist, however. One of the main risks is that the fund may not be able to meet redemption requests promptly. This could occur if there is a sudden change in demand for the fund.