Determinants of ETF Liquidity in the Secondary Market : A Five Factor Ranking Algorithm

There are about 900 ETFs trading in the market, of which a large number appear to be duplicative in design and coverage. Some of them possibly serve as a tool for issuing firms to gain market share. We suspect that many of the newer funds have low liquidity, asynchronous trading, and wider bid-ask spreads. This article develops a five-factor liquidity scoring algorithm that enables a ranking of ETFs from the most liquid to the least liquid. The authors present the top and bottom 50 ETFs from this ranked liquidity list. They also find that there is a very active bond ETF market, as evidenced by the fact that about 20% of the most liquid ETFs are bond-based. The factors that the authors find most indicative of liquidity are a lower bid-ask spread, a higher market capitalization, a lower expense ratio, and higher average trading volume. In contrast, the least liquid funds have larger bid-ask spreads, smaller market capitalizations, higher expense ratios, and much lower investor interest as proxied by trailing 3-month daily trading volumes. While low-liquidity ETFs may provide the investor with exposure to a very narrow market segment, the costs of trading, market price impact, and ease of establishing or unwinding a sizable position must be carefully evaluated before initiating holdings in ETFs that exhibit low liquidity