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Here's How to Trade Low Volume ETFs

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ETF volume should not be interpreted the same way as stock volume. The key is to determine the intrinsic value of the product.

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MINYANVILLE ORIGINAL Don't dismiss ETFs simply because they have low daily trading volume; instead you need to understand how ETFs trade. Some individual traders ignore ETFs with low daily trading volume figuring there won't be enough volume to trade in any size, even 1,000 or 2,000 share pieces.

The volume question also comes up with institutions as to whether they can trade "thin issues"; that is, ETFs that report low daily volume on quote machines and computers.

But ETFs do not trade like stocks, and the daily volume that is shown on computer screens is only the tip of the iceberg for the potential size of ETF trading. Most traders are used to trading stocks, especially small-cap stocks, that have a bid and asked quote, and large orders can sop up available stock and then move the stock higher or lower, depending on availability of stock for sale or purchase. ETFs are not like this.

Paul Weisbruch, Vice President of ETF trading at Street One Financial, says his firm functions as an agency liquidity provider by finding the best price for ETF trades. He says that ETF daily trade volume numbers are not that meaningful, and that ETF volume should not be interpreted the same way as stock volume.

Weisbruch says that with "plain vanilla" equity ETFs -- those that trade millions of shares a day, such as SPY or IWM -- investors know what the true price of the ETF is at any time. These ETFs are efficient at tracking the price of the underlying index.

But there are ETFs other than the seasoned and popular ones. There are over 1,400 ETFs listed on exchanges. As well, the varieties of strategies are wide, adding complexity and making it harder to track the underlying index.

For instance, the rules are different for domestic equity ETFs and a China-based ETF, or frontier country ETFs, or commodity-based ETFs, or fixed income ETFs. In those ETFs the underlying indexes are not traded at the same hours as the ETFs that replicate those indexes.

How does a big order in a "low volume" ETF get filled?

If an institution gives Weisbruch a big order -- for instance, a half million or a million share buy order -- in a fairly thinly traded ETF, this would probably necessitate a creation process. "The creation, redemption process largely happens behind the scenes after the trade takes place, after the trading day," Weisbruch says. The two sides of the trade agree on a price and volume and consummate the trade, and later the ETF shares are redeemed or created.

When given an order, Weisbruch goes into the marketplace to find the other side of the trade. Through what he calls his "natural liquidity pool" he checks the market, looking for bids and offers to find the most competitive markets. Weisbruch will complete a big order by finding the right buyer or seller, and that could happen right away.

If it doesn't happen right away, he could show the order to the Street in an anonymous way, to compress spreads and furthering price discovery. This could take minutes or hours, and Weisbruch will work at finding the other side of the trade, trying to mitigate any price impact.

After the trade is done the block will be reported. If a trader notices a large increase in volume in a thinly traded ETF, the trader can check with the ETF issuer to see if there was a buy or sell block to account for the volume. A trader can also check on Bloomberg or IndexUniverse.com, or any other source that tracks inflows and outflows, to find out what sort of block caused the increase in volume.

A trader can usually buy or sell what looks like low volume ETFs efficiently. Weisbruch says that having information about the value of the underlying index is important in getting a big trade done.

According to Weisbruch, "Many times there is a large dislocation between volume and perceived liquidity. Some ETFs might have a $0.20 difference between the bid and asked quote, and have little daily volume. You might be able to price a significant sized order, a hundred million dollar order or more in between the bid and asked, and get the trade done. This is because the underlying value of the ETF, the prices of the components comprising the underlying index, is probably between that bid and asked spread."

For those who trade in smaller pieces, Weisbruch advises not to put in market orders, but to first get the intrinsic value (IV) of an ETF.

Most quoting systems have the IV, and generally the way to get the IV is to type in the symbol and then .IV, such as SPY.IV or IVV.IV. The IV is usually given by free services, and Weisbruch says the IVs are not always exactly accurate but "usually fairly accurrate" for domestic, equity ETFs, but not for alternative ETFs such as fixed income, commodities, some currencies, and some frontier markets.

Weisbruch says if an investor or trader puts his or her order in on a domestic equity ETF within about $0.05 of IV, the investor will probably get filled. The investor must be careful, however, because the IV changes as the market changes, and in volatile markets the investor can miss a market.

If an investor wants to buy a non-domestic equity ETF, such as China, which is not open in the US market time, the investor will also probably get filled putting in an order within $0.05 of the IV. Smaller orders are usually filled, but not larger institutional orders, which is a different animal.

Editor's Note: For advice from top asset managers on using ETFs, see Max Isaacman's Winning With ETF Strategies in the Minyanville Book Store.
No positions in stocks mentioned.
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