ETF Liquidity: Thinly Traded ETFs Are Not So Bad

A common argument against exchange-traded products over the past several years has been a lack of liquidity slack trading volumes. The argument does not pertain to the SPDR S&P 500 SPY, which sports average daily volume of more than 166.1 million shares over the past three months. Nor does it apply to SPDR Gold Shares GLD, which features volume of over 10.4 million shares per day, or plenty of other ETFs. Still, there are plenty of ETFs and ETNs that have volume that is so sparse, investors can be left thinking a low volume product is a bad product That is not always the case, according to a report by TrimTabs Investment Research. "Thinly traded securities can be a liquidity landmine, but the same wisdom that protects investors from the perils of low trading volumes is largely irrelevant to exchange-traded funds," TrimTabs said in the report. The ability of thinly traded ETFs to generate positive returns has previously been documented, but the TrimTabs research notes some lightly traded funds outpace their more heavily traded counterparts. Even with that fact, investors tend to look at ETF volume the same way they look at an individual stock's volume and that is to infer low volume is bad. "Because exchange-traded funds trade so much like stocks, many investors assume that the daily trading volume of an ETF is a key indicator of the fund's liquidity," TrimTabs said. Well, ETFs simply are not built that way. "If the common stock of a public-listed company has a low trading volume and a limited amount of shares trading in the open market, a large buy or sell order can have a tremendous impact on the price of those shares. In contrast, a low trading volume in a U.S. Equity ETF is not a sign that the ETF has low liquidity. ETFs are structured so that any investor (retail or institutional) can execute large orders with no impact on an ETF's price." Said another way, an ETF's liquidity has more to do with the volume of its underlying components than it does with the fund's actual volume. What that means is that an ETF itself can low average daily volume, but the fund will not suffer from poor liquidity if its holdings are heavily traded. The SPDR S&P Energy Sector ETF IPW is just one example of this scenario. IPW's average daily volume over the last three months is less than 1,230 shares. However, Royal Dutch Shell RDS, BP BP and Total TOT – Europe's three largest oil companies – combine for about 37 percent of IPW's weight and the U.S.-listed versions of those stocks combined see daily turnover in excess of 13 million shares. "The separation between ETF pricing and total shares outstanding is the most important concept to grasp, in our opinion, because daily trading volume of an ETF is mostly governed by the ETF's size" TrimTabs noted. "ETFs with a higher market value will correspondingly have a higher average daily trading volume, as increased demand for a particular ETF enables the authorized participant to create more shares of the ETF, causing more of its shares to be traded between secondary market participants during the day. "Investors concerned about an ETF's liquidity have to consider the liquidity of the underlying basket of securities in that ETF's portfolio. ETFs that generally invest in securities in overseas markets will have lower liquidity because international securities tend to be less liquid than U.S. securities." Authorized participants issue new shares of an ETF when demand tops the current number of shares outstanding so the fund's net asset value and the underlying securities are not impacted. In its report, TrimTabs compared 40 long-only high-volume (30-day ADV of more than 1.6 million shares) ETFs focused on U.S. equities against 40 similar funds with ADV of less than 1,500 shares and assets under management of less than $10 million. Not surprisingly, the report notes that more heavily traded ETFs have dominated their less popular rivals in terms of attracting inflows. Part of that can be blamed on some institutions forbidding traders and money managers from purchasing securities that do not meet certain volume criteria, but the dominance of heavily traded ETFs in terms of raking in investors' cash can also be attributed to other factors. "Familiarity Bias: We believe this behavioral finance bias encourages investors to interpret liquidity of ETFs as similar to stocks, and therefore discourages them from selecting ETFs with low trading volumes," according to TrimTabs "Investorsgenerally feel more comfortable with larger and more well-known products." Since some low volume ETFs are guilty of not trading everyday, it is vital that investors use net asset value to compare heavily traded funds against less popular rivals because even when an ETF does not trade, it will always have a closing NAV because its components did trade. "Using an NAV to analyze performance, we found that performance currently slightly favors low-volume ETFs. We will stipulate that the relative comparison period of nine months is quite short, but it seems that for the moment, low-volume ETFs are outperforming their higher-volume counterparts," TrimTabs said. Over the nine-month period, the low volume ETFs examined by TrimTabs returned 22.02 percent compared to 21.45 percent for the high volume funds. Dispersion of returns with high volume ETFs is also much lower than the dispersion of the lower-volume ETFs, according to TrimTabs. The highest volume ETFs showed dispersion of 0.99 percent compared to 2.22 percent for the low volume funds, the data indicate. Dispersion is a mathematical term used to indicate a set of values relative to the average area or level. For on light volume ETFs, click here.