Reader David pointed to a link titled “ETFs With Little Volume but Big Returns, Revisited” and commented as follows:
This article discusses “wide-spread confusions” re the significance of an ETF’s average daily volume, or per-minute dollar amount traded.
I am one of those confused, and I would appreciate your discussion of this article. I recall you writing that you avoid ETFs with low daily volume, such as TF (vs. THD) or TKF (vs. TUR), even though they are included in the weekly stat sheets.
The article is quite lengthy, so I will hone in only on the following:
All of this being said, there still exist “screening metrics” that appear from time to time in the ETF media or are simply part of an institution’s or an advisory firm’s “rules of thumb” that “require” that ETFs/ETN’s trade a) 100,000 shares on an average daily volume basis b) Have a certain level of AUM within the fund, i.e. $100 million and c) Have to adhere to a specific width between the published bid/ask quotes. We at Street One Financial find that because there is such a bevy of ETF/ETN products in the universe (equity, fixed income, commodity, actively managed, currency, long/short, etc.) that rules of thumb such as those above are not consistent with reality and often limit the strategies available to the ultimate end user of the ETF/ETN.
In essence, these “rules” address ETFs and ETNs as if they were individual small cap stocks from a feasibility of trading standpoint and largely this practice of installing such screens is akin to investing with “blinders” on. And in a world of increasing ETF usage, limiting your strategies due to embedded misconceptions regarding “trading volume and liquidity” simply handcuffs your overall performance and competitive ability because in order to keep pace with peers, one must often venture into new strategies as they become available or at least have the capacity to be nimble where necessary…
It’s hard to understand how someone could consider common sense screening as “investing with blinders on.” While some of the screens maybe a little farfetched, investing in ETFs without basic consideration to volume and bid/ask spreads is simply being ignorant.
Here’s my take on it. If you are an investor with small amounts of money to deploy, there is nothing wrong with selecting ETFs with a small asset base and or low trading volume. That’s one of the reasons while my weekly StatSheet includes those types of ETFs as well.
However, if you are a large investor or, as in my case, manage other people’s money in the 10s of millions of dollars, you better use some kind of screening mechanism to assure you can get into and out of the market without too much slippage.
As an example, you do not ever want to get caught trying to trade out of an ETF with an average daily volume of 100,000 shares when you are trying to liquidate 500,000 shares. You will move the market and will not get efficient execution and may take more of a haircut than you like.
On the other side of the spectrum, there is SPY. It has an average daily volume of over 162 million shares (over $1 billion), which accommodates just about any size of investor.
Personally, in my advisor practice, my screening rules are fairly simple. I do not invest in any ETF that does not have an average daily volume of $10 million. Having used that rule for a while, I have always been able to get in and out of a position very effectively.
How many ETFs exist that sport this kind of volume? Out of the 500 I track, I have identified 87. That is enough to pretty much cover any asset class you need or want to have exposure in.