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ETFs With Little Volume But Big Returns


If you're screening ETFs by volume, you're excluding beneficial strategies based on a misconception.

Editor's Note: Paul Weisbruch is 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.

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.
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No positions in stocks mentioned.

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