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The Truth About Low Volume ETFs


A key aspect of ETF investing afflicts nearly all investors no matter the product type: Volume.

Although ETFs have begun to surge in popularity over the past few years, there are still a few misconceptions about how the products work. While mistakes are often made when it comes to how to utilize leveraged and inverse funds or commodity and volatility products in a portfolio, another key aspect of ETF investing afflicts nearly all investors no matter the product type: volume.

Volume, or the number of shares trading in a particular period, is regarded by many as the basis for liquidity in the stock world. The more shares that trade in a particular security, the easier it will be to move in and out of it, keeping bid ask spreads tight for popular stocks.

When investors apply this logic to ETFs, the resulting thinking is that high volume funds are extremely liquid while low volume ones, much like thinly traded stocks, should be avoided by most. After all, it is only natural to assume that ETFs are like stocks in this regard as both are exchange-traded and many ETFs are just baskets of stocks anyway.

However, this isn't always true as, unlike a regular stock, an ETF doesn't rely on its actual volume to generate liquidity. Instead, an ETF's volume is dependent on its underlying holdings for its actual liquidity.

Say What?

The above statement is true because of how ETFs are structured and how new shares are created in a fund. Basically, what is called an Authorized Participant ("AP") can step in and buy up securities in order to create a new basket of ETF shares, or trade in ETF shares for underlying securities as need be.

Due to this feature, ETFs often trade quite close to their net asset value ("NAV"), since when prices deviate too far-either high or low-the Authorized Participant can step in to balance the process out. Thus, when ETF prices are too high compared to the NAV, the AP creates more ETF baskets while when the ETF prices are below the NAV, the shares are traded in by the AP for the underlying securities.

The AP profits from the spread differential in this arbitrage-like move, which also helps to keep ETF prices in line with their NAV so that everyone wins in this creation and redemption process (read ETFs vs. mutual funds).
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No positions in stocks mentioned.
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