Many advisors, institutions and investors use average daily trading volume to base investment decisions. However, the common notions of liquidity, specifically the term "illiquid," can not be aptly applied to the exchange traded fund investment vehicle.
"Abused notions such as 'Only invest in ETFs that trade at least 100,000 shares of average daily trading volume,' and 'Only invest in an ETF that has at least $100 million in AUM' have become common in the popular ETF media as well as being major drivers of faulty decision-making across the advisory community," according to slides prepared for a webcast by Street One Financial and FA Magazine.
ETFs are based on a basket of underlying securities. As such, an ETF is only as liquid as its underlying stocks, bonds or other component holdings.
"Illiquid should be reserved for only 'illiquid' products such as Hedge Funds and Private Equity investments that may be subject to lock-up periods and other obstacles in selling a position," according to the webcast.
For any given ETF, the "visual" or "perceived" liquidity may show a wider bid/ask spread than an investor or advisor is willing to take.
"But this is quite normal, and acceptable for an ETF," Street One Financial said.
Instead, one should look at the ETF's Intraday Indicative Value, the IIV or NAV, for transparent, predictable trade executions. The only exception to this is for ETFs that included international holdings since securities are traded on different time zones.
Typically, the IIV should fall in between the bid/ask spread. When placing trades, investors should anticipate some wiggle room so that orders can be fully executed. Market makers and liquidity providers will help fill the trades, but they do not trade for free.
Street One Financial suggests that investors keep in mind what the potential price impact would be when placing an order and if they need to fill the position in its entirety or across a period of time. Moreover, when entering an order at the trading desk, the firm also advises to place a "top" to establish the most you are willing to pay to fill the order while maintaining some level of price control.
Max Chen contributed to this article.