What is liquidity and why is it important?
One of the most important considerations for anyone investing in financial markets is the ability to access their money should the need arise. The ease at which this is possible is defined by the liquidity of the underlying asset, be it stocks, bonds, commodities, or real assets.
So, what is liquidity
Simply put, liquidity refers to how quickly you can convert an asset into cash while maintaining its value. An asset that can change hands quickly can be described as liquid. One that takes longer to sell is considered less liquid—or illiquid.
A helpful way of thinking about liquidity is to consider the ease with which a transaction can be completed. We can see the effect of this in our day-to-day lives. Selling a bike on an online auction website is generally quicker and easier than selling a car. Selling a house will likely take longer still, as transactions become more complex and costly.
In stock markets, company shares sit across the liquidity spectrum. A stock can be considered liquid, if its shares can be bought and sold quickly, and with minimal impact to the stock’s price. The shares of multibillion-dollar companies traded on major stock exchanges tend to be highly liquid. These are known as large-cap stocks and are traded in high volumes on any given day. The average 10-day trading volume for Toronto-Dominion Bank, for instance, was roughly 11 million as of April 19.¹
Smaller companies—or small-cap stocks —are typically listed on smaller stock exchanges. They’re usually less liquid, which implies greater liquidity risk. And because they’re not traded as frequently, any sudden change in demand can create significant market volatility.
Volume and bid/ask spread
While there are no hard rules to determine whether an asset is liquid or illiquid, a useful way to determine the liquidity of an individual stock is to analyze its bid-ask spread and volume. This essentially boils down to supply and demand, with the bid referring to the highest price an investor is willing to pay for a stock and the ask representing the lowest price at which an investor is willing to sell for. Because these two prices must meet for a transaction to occur, consistently large bid-ask spreads imply a low trading volume for the stock, while consistently small bid-ask spreads imply high volume.
For example, a bid of $9 and an ask of $10 results in a bid-ask spread of $1. The bid-ask spread can also be given as a percentage of the lowest sell price or ask price. In the example above, the bid-ask spread in percentage terms is 10% ($1 divided by $10). This is a fairly large spread—the spread on a more liquid stock is often a difference of cents.
The illiquidity premium
Because there’s less risk of not being able to quickly convert your investment to cash when investing in liquid securities rather than illiquid ones, illiquid assets tend to have higher expected returns (a risk premium) as compensation for their incremental risks and higher costs of trading. Larger, long-term investors, such as pension plans and insurance companies, are able to use the associated risks to their advantage and diversify their portfolios with illiquid real assets that not only suit their long-term investment horizons, but also offer the potential of additional returns. This is often described as the illiquidity premium.
Mutual funds and ETFs
When considering mutual funds, liquidity risk takes on a slightly different form. If the underlying assets are illiquid, a fund may not be able to meet redemption requests without significantly diluting the interests of any remaining investors. This can be a particular issue in times of market volatility, when many investors may wish to withdraw their money from the fund at the same time. Mutual funds and exchange-traded funds (ETFs) are designed in a way that enables investors to redeem their investment at any time, which make them highly liquid, but the liquidity of the fund’s underlying holdings is a vital component in this agreement.
To address the potential mismatch between the liquidity of a fund’s holdings and redemption requests at any given time, guidance has been published by the Canadian Securities Administrators (CSA) to encourage investment fund managers to address liquidity issues affecting Canadian investors.
As part of Canadian securities legislation, investment fund managers are obligated to have procedures in place to help mitigate risks tied to a fund’s business. Considering fund liquidity is one of those risks, investment fund managers are required to establish a framework to address it, by taking into account the liquidity of a fund’s holdings, the time it takes to liquidate each holding within a fund, and any potential redemption patterns.2
Do your homework
An investor’s ability to buy and sell assets is central to their confidence and ability in the marketplace. There are no hard-and-fast rules for whether a stock is liquid or illiquid, but as we’ve shown here, there are several important measurements that can be used to get a good idea.
For investors unsure of going it alone, opting for a mutual fund can be a sensible alternative. With firm guidelines in place to prevent liquidity becoming an issue, these funds are able to safeguard access to your money when it’s needed.
1 S&P/TSX Composite Index, as of April 19, 2023
2 Guidance on Effective Liquidity Risk Management for Investment Funds, Canadian Securities Administrators, September 18, 2020.
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