Risk: Liquidity

What does tax domicile Liquidity mean?

Sometimes ETFs and other types of funds will invest in assets or asset classes that are difficult to transact in. When something is difficult -- or impossible -- to buy and sell quickly (e.g. in one or two days) and at a fair price, we say that it is an "illiquid" investment.

Illiquid investments include some bond ETFs and funds, small-cap ETFs and funds, physical commodities, property, venture capital, and other ETFs and funds which invest internationally.

For an extreme example, imagine an ETF that invests in physical residential property in Australia. It's very difficult to buy and sell a physical property quickly, for a good price. However, an ETF can be bought and sold every day on the stock market. This mismatch would create a big liquidity problem because there's no way an ETF could buy or sell a property multiple times each day.

If such an ETF was proposed it's likely that the price of the ETF (what you see in your brokerage account) and the actual value of the properties inside the ETF (commonly referred to as the "net asset value" or NAV) would severely 'dislocate' or deviate from one another. For example, the ETF's share price could be $15 but the NAV (value of the properties that one ETF share represents) could be $10. If an investor bought the ETF, they would be over-paying for the assets by 50%. As you can see, it would create issues for investors.

Of course, that's an extreme example to illustrate our point about liquidity. However, please note that during the Global Financial Crisis of 2008/2009 the prices of some US-listed bond ETFs 'dislocated' from their true value by as much as 15%!

Here are some of the risks to consider when investing in an ETF which could present liquidity issues:

  • Use a "limit order" in your brokerage account, rather than a 'market order'. Market orders can bounce up and down during the trading day whereas a limit order sets a limit on the price you pay (before you do anything, check your brokerage firm's terms and conditions and call them if you're confused about how they place orders!). If an ETF is illiquid, the price could bounce around more significantly than other, more liquid ETFs.
  • Avoid buying and selling these ETFs during market turmoil or high volatility. We believe this is the most likely time you will see a dislocation between prices and the NAV. Try to place your limit order during the trading day when activity should be at its highest, rather than setting the order in advance or overnight.
  • Study the buy-sell spread of the ETF on our website or on the ETF issuer's website. Most illiquid ETFs have wider buy-sell spreads. As a reminder, while it's not a 'cost' you pay to the ETF provider/issuer, the spread is an indirect expense that an investor has to pay to get in or out of the ETF. The lower the better.

One final note we'll add for an illiquid ETF is that some ETF issuers can provide exposure to the asset class by using derivatives and not actually "physically" owning the assets that you expect them to own. These ETFs will have some language in the PDS which tells you if they are allowed to use derivatives. It's common for some bond ETFs and small-cap ETFs to use futures contracts (a type of derivative) instead of owning all of the assets inside the ETF.

  • Full replication: This means the ETF buys everything in the index it claims to track.
  • Partial replication: Typically, this means the ETF can use derivatives or other ways of providing 'most' or 'all' of the expected returns of the index. For example, instead of owning all 300 shares inside the ASX 300 share market index, it might own the largest 200 and then own a smaller part of the remaining 100 or use a derivative contract.
  • Synthetic ETFs: usually applied to commodity ETFs, this means the ETF or fund does not physically own or store the commodities but uses a contract/derivative over the index (e.g. it does not own actual oil barrels in a warehouse)


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