What Is Liquidity Risk?
Liquidity risk is the cost and difficulty of converting your shares back into cash without moving the market price significantly.
In plain terms: Can you buy and sell quickly at a fair price?
For large-cap stocks like Apple or Microsoft, this is trivial. Millions of shares trade every second. You can sell $1 million of AAPL and get filled in milliseconds at nearly the exact market price.
But for a small ETF with $50 million in assets, you're one of a handful of holders. If you try to dump your position, there may be no ready buyers. You either have to:
- Accept a lower price to find a buyer
- Place a bid and wait (sometimes for weeks)
- Hold and hope liquidity improves
This hidden cost is liquidity risk. And for income investors—who often need to rebalance or exit positions—it's critically important.
Why AUM Matters Most
Assets Under Management (AUM) is the total market value of all holdings in an ETF. It's the single best proxy for liquidity.
Here's how it breaks down in the dividend ETF space:
| AUM Range | Liquidity Grade | Typical Bid-Ask Spread | Risk Level |
|---|---|---|---|
| $500M+ | Excellent | $0.01-0.03 | Minimal |
| $100M-500M | Good | $0.03-0.10 | Low |
| $50M-100M | Fair | $0.10-0.30 | Moderate |
| $10M-50M | Poor | $0.30-1.00+ | High |
| <$10M | Critical | $1.00+ | Extreme |
Real Cost Example: The Bid-Ask Spread Trap
Let's say you have $50,000 in a specialty dividend ETF trading at $100/share. It sounds liquid—you bought it easily.
But the fund only has $60 million in AUM. The bid-ask spread is $0.50.
Your Entry and Exit Costs:
- Purchase: You buy 500 shares at $100.25 (the ask) = $50,125
- Year 2 Exit: Market price is still ~$100, but the bid is only $99.75
- You sell 500 shares at $99.75 = $49,875
- Round-trip cost: $250 (0.5% of your position)
That's $250 that never went toward your returns. It just evaporated. And if the spread widens during volatility (which it always does when you need to sell), you could lose 1-2% or more.
Compare this to JEPI, which has $25+ billion in AUM. The bid-ask spread is usually $0.01. On the same $50K position, your round-trip cost is under $5.
AUM & Market Impact: Why Your Order Size Matters
Here's another critical issue: market impact.
In a deep, liquid fund, selling $50,000 of shares has zero impact on price. There are thousands of daily buyers waiting.
In a thin fund with $40 million AUM, your $50,000 order might be 5-10% of the daily volume. When you hit the market, you've just become the marginal seller. Prices move against you.
This is especially dangerous during market stress. When you're most likely to need cash (market downturn, emergency), liquidity vanishes. Spreads explode. You end up selling at the worst time at the worst prices.
New ETF Launches: Convenience or Trap?
Every dividend ETF starts small. New funds are launched constantly—YieldMax alone has 50+ dividend ETFs, many under $100M.
The Danger: Advisors and marketing push new launches because they're "hot" and "optimized" and "the latest strategy." But the fund might be $15 million AUM with 2-3% spreads.
You might buy it excited about the 8% yield. Two years later, the fund still hasn't gathered meaningful assets. Spreads remain wide. Institutional investors haven't adopted it.
Then: The fund closes.
And you're forced out at an unfortunate time with no choice.
Institutional vs. Retail Ownership: A Hidden Signal
Here's a secret the pros use: Check the fund's ownership composition.
If a fund has solid AUM but low institutional ownership, it signals trouble. Why aren't big money managers in it? Maybe:
- The strategy has structural flaws
- The fund charges too much in hidden fees
- The provider has credibility issues
- NAV tracking is poor
Conversely, if a fund has strong institutional ownership—pension funds, endowments, major advisors—it's a positive signal. These entities do deep due diligence. Their presence validates the fund.
How to Check Institutional Ownership:
- Go to the ETF's factsheet on the provider website
- Look for "Shareholder Composition" or "Institutional Ownership %"
- If under 20% institutional, be cautious (retail-driven funds are fragile)
- If 50%+, it's a signal the fund has professional credibility
Fund Closures: The Silent Wealth Destroyer
ETF closures are a dirty little secret. Funds with low AUM routinely shut down.
When a fund closes, shareholders face:
- Forced liquidation: You can't just hold forever. Your shares are sold and you get cash.
- Tax surprise: The liquidation triggers capital gains you weren't planning for.
- Reinvestment lag: You get your cash but have to redeploy quickly (usually into a higher-AUM fund), often at worse valuations.
- Lost dividend timeline: You might miss ex-dates and dividends you expected.
And here's the kicker: There's rarely meaningful advance notice. The provider might announce closure with 30-60 days' warning, leaving you scrambling.
Case Study 1: YieldMax Options Explosion
YieldMax has launched 50+ options-based dividend ETFs in the last two years. Many are excellent funds with strong performance. But several have attracted minimal assets.
Consider a hypothetical YieldMax Earnings ETF launched in 2023. It promised a unique earnings-capture strategy. Initial buzz was strong. But institutional investors stayed away (due diligence concerns). Two years later: $12 million AUM, 1.5% spread, zero institutional ownership.
The provider eventually closed it. Retail holders got liquidated. New strategy, same problem: Low AUM traps.
Case Study 2: Defiance's Options Laundering ETFs
Several Defiance options-based funds have launched with promising names but underwhelming adoption. Some grew to $200-500M (viable), but others stalled under $50M.
The survivors had strong brand recognition (Defiance is a known provider) and institutional interest. The stalled ones didn't survive long.
Case Study 3: Invesco and iShares Closures
Even major providers close funds regularly. In 2023-2024, Invesco and iShares each closed 20+ ETFs due to low adoption.
Some were specialty dividend funds. The pattern: Small AUM, slim margin, closure within 5 years.
How to Evaluate Liquidity Risk
Here's a practical framework for evaluating any dividend ETF:
Step 1: Check AUM
Open the fund's factsheet (provider website) and note the AUM.
- $500M+: Acceptable for most portfolios. Spreads will be tight.
- $100M-500M: Viable, but monitor. Growth trend matters.
- $50M-100M: Caution. Liquidity risk is real. Closure risk exists.
- <$50M: Avoid unless you have a specific tactical reason (very short holding period).
Step 2: Measure Bid-Ask Spread
Open your broker and note the bid-ask spread during market hours.
Formula: (Ask - Bid) / ((Ask + Bid) / 2) × 100 = Spread %
Example: Bid $99.80, Ask $100.00 = ($0.20 / $99.90) × 100 = 0.2% spread
- <0.10%: Excellent. Safe to trade any size.
- 0.10-0.30%: Good. Acceptable for most investors.
- 0.30-0.50%: Fair. Noticeable cost on large positions.
- >0.50%: Warning sign. High cost and market impact risk.
Step 3: Check Institutional Ownership
If available on the factsheet, note institutional ownership percentage.
- 50%+: Strong signal. Professional endorsement.
- 20-50%: Mixed. Viable but monitor.
- <20%: Red flag. Retail-dependent, fragile.
Step 4: Track AUM Trend
Check if AUM is growing, stable, or declining.
- Growing: Positive signal. Market confidence in the fund.
- Stable (2+ years): Acceptable. Mature fund with constituency.
- Declining: Warning. Investors are leaving. Closure risk rises.
The Safe Dividend ETF Portfolio Rule
Here's a simple rule for building a low-liquidity-risk portfolio:
80% in funds with $500M+ AUM. 20% in smaller funds ($100M-500M) only if you have a specific tactical reason.
This keeps your portfolio resistant to spreads, market impact, and closures. You can rebalance without friction. You sleep well.
What About New Strategies?
One last question: What if you want to buy a new dividend fund with a genuinely novel strategy, but it's only $20 million AUM?
Answer: Only allocate what you're willing to hold through closure.
If a new fund is genuinely compelling, you might allocate 2-3% of your portfolio as a "test" position. But don't make it core. Don't assume it'll survive. And don't be surprised when spreads are wide and you can't exit quickly.
Give the fund time to gather assets and prove itself. Once it hits $200-300M AUM with stable ownership, consider promoting it to core holdings.