ETF Liquidity

Forbes featured an article titled “Mutual Fund or ETF: Which Is Right For You?” While most of the information posted is well known, I want to hone in on one segment addressing the liquidity of ETFs. Here are some highlights:

Liquidity is usually measured by the daily trade volume, which is generally expressed as the number of shares traded per day. Thinly traded securities are illiquid and have higher spreads and volatility. When there is little interest and low trading volume, the spread increases, causing the buyer to pay a price premium and forcing the seller into a price discount in order to get the security sold. ETFs, for the most part, are immune to this. ETF liquidity is not related to its daily trading volume, but rather to the liquidity of the stocks included in the index.

Broad-based index ETFs with significant assets and trading volume have liquidity. Narrow ETF categories and even country-specific products have relatively small amounts of assets and are thinly traded. ETF liquidity could dry up in severe market conditions, so you may wish to steer clear of ETFs that track thinly traded markets or have very few underlying securities or small market caps in the respective index.

ETFs have exploded onto the investment arena over the past few years with now over 700 of them being available, of which 447 are currently featured in my weekly StatSheet. I have recently removed some and will continue to do so while adding others.

Just because a huge variety of ETFs specializing in many sectors is offered does not mean that they are suitable for investment. Some have trading volume of only a few hundred shares per day, which makes me wonder if they can even survive.

Remember, one of the reasons many investors select an ETF over a mutual fund is that it can be traded during the day allowing faster portfolio adjustments due to market conditions. This also means that you want to be able to get in or out quickly, which only works if liquidity is not an issue.

When choosing an ETF, be sure to make liquidity one of your selection criteria so that you don’t get stuck giving back too much in profits or unnecessarily increasing losses due to low volume not being able to accommodate your order efficiently.

For me personally it means that I want to see at least 3 times the average trading volume of the order I am planning to place.

For example, using SH for our hedge strategy, I was able to fill a $2 million limit order in about 20 seconds. Of course, SH trades on average 2 million shares a day, which amounts to trading volume of some $150 million; that made my order insignificant and helped me to get a speedy execution.