ETFs With Little Volume But Big Returns

If you speak to a product sales representative from an ETF issuer, you’ll likely hear a consistent message from him or her. And it’s not “if you build it, they will come,” but instead, “if there’s trading volume, they will come.”

It can be quite frustrating that quality ETF products that are available to investors and portfolio managers are “screened out” by potential end users because of popular misconceptions about trading volume and how it relates — or in fact, doesn’t directly relate — to liquidity. An often repeated mantra in the ETF industry is “ETFs are open-ended funds, with an unlimited number of shares available that can be created or redeemed on demand.” Furthermore, most ETF investors have heard the rhetoric “Because of an arbitrage mechanism, ETFs generally don’t trade at significant discounts or premiums to their Net Asset Value, unlike closed end funds.”

What does this all mean? It means that with or without trading volume, ETFs are constantly re-pricing all day, every day, because the ETF vehicle itself is tied to an underlying basket of securities that’s trading out there in the open market, and thus that basket’s value is changing constantly. So think of the underlying basket and its re-pricing mechanism as being the tail that wags the “dog” — that being the ETF itself.

Granted, thinly traded ETFs can have “stale” pricing on the electronic screens because there are less “eyes” on them, but portfolio managers and investors would serve themselves well if instead of “screening out” ETFs from their investment methodology and models that are a) newer to the market b) have low Assets Under Management (AUM), and c) have low trading volume, they’d base their judgment on an ETF’s viability in their portfolio on the fund’s performance and how closely it meets its stated objective.

Furthermore, the ETF industry would do itself a great service if it discarded the terms “illiquid ETFs” and instead referred to less active ETFs as “thinly” or “lightly” traded versus the “heavily” traded ETFs. Perhaps that would get people out of the train of thought of equating an ETF’s liquidity with its published average daily trading volume.

At Street One, we generally tell portfolio managers that we speak with to leave “trading volume” out of their screening process for product quality and viability until they have whittled down their “short list” to a handful of ETFs that best meet their portfolio objectives. Now they’ve reached a point where the best products are on the table and they can screen by net performance after fees, how closely the ETF follows its stated methodology, how tax-efficient the product is (does it historically spin off capital gains taxes? etc.), and how comfortably and efficiently the ETF can be traded, especially in larger size.

Note that I’m careful to say neither “how liquid the ETF is” nor “how much trading volume the ETF has.” A number of thinly traded ETFs are based on extremely liquid underlying indexes, and on any given day, with or without volume, an investor can establish a large position with minimal price impact (or take off a large position), provided they know how to trade correctly (not using market orders and utilizing a liquidity provider/trading desk when possible for accurate pricing). And conversely, there are a number of high-volume ETFs that aren’t exactly easy to trade, like certain fixed-income ETFs, and investors should be wary of price impact when placing orders and not blindly assume that because there’s volume, there’s safety in liquidity. The key to the investor is to become comfortable with how liquid an underlying index is that a given ETF tracks, so that potential price impact expectations (for their future buys and sells) can be built into their models. In the ETF world, volume isn’t liquidity, and liquidity isn’t volume.

So if you’re a portfolio manager that’s been “screening” your universe of ETFs by volume this year, perhaps excluding all of those ETFs that trade less than 50,000 shares per day — or worse, less than 100,000 shares per day — you’ve excluded a major part of the ETF investment universe and countless strategies that could benefit your portfolio based on a popular and persistent misconception. It’s true that bid/ask spreads tend to be much tighter on heavily traded ETFs and there’s generally larger displayed “size” on the bids and offers on electronic screens for these same ETFs, but what really matters is what the true price impact of your buy or sell orders is on a given ETF, not what the trading volume or the visual bid/ask spread display.

True, it can be harder to ascertain the potential price impact of orders and true underlying liquidity for newer, thinly traded issues. And it might even require a phone call to an ETF liquidity provider, your trading desk, or a friendly rep at an ETF issuer. If your goal as a fiduciary is to seek out the best products, these quick phone calls are worth it! Perhaps you may be pleasantly surprised that there’s deep actual liquidity in thinly traded ETFs that have caught your eye in the past, but that you’ve dismissed because of low trading volume, and now you just need to execute your trades better and smarter. So with one quarter of performance nearly in the books for 2010, let us take notice of top-performing, lightly traded ETFs that fly under most everyone’s radar because of low trading volumes.

Do you own these products in your portfolio? Not likely, if you’re screening by trading volume and waiting for that magical day where these ETFs may average more than 50,000 or 100,000 shares per day. Because many of the ETFs on the market today represent specialized sectors, asset classes, and unique index or active methodologies, these ETFs aren’t as mainstream as the household names like (DIA), (SPY), (QQQQ), (IWM), and so forth, so these ETFs may never trade heavy volume because they may not appeal to the masses. But that doesn’t mean they deserve to be forever ignored by investors and portfolio managers as viable investment vehicles. In the meantime, you owe it to yourself and your practice to give some of these products a second look and find out how liquid these ETFs really are before dismissing them on the basis of trading volume. Make that phone call!

Equity ETFs (Average Daily Volume < 50,000 shares)


Leveraged Equity ETFs (Average Daily Volume < 50,000 shares)


Fixed Income ETFs (Average Daily Volume < 50,000 shares)
***Denotes Leveraged ETF


Commodity ETFs/ETNs (Average Daily Volume < 50,000 shares)
***Denotes Leveraged ETF


Originally published on Minyanville

Story was written By Paul Weisbruch the VP of ETF/Index Sales and Trading at Street One Financial, an ETF liquidity provider focused on quality trade execution as well as portfolio construction and product strategy in the ETF space.

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