Most investors have grown used to the habit of avoiding stocks with low trading volumes, however, this mindset should not be applied to exchange traded funds.
Typically, investors who execute orders on lightly traded stocks will see significant changes when buying or selling the stock, but this phenomena does not occur when trading with ETFs, writes Tom Lauricella for The Wall Street Journal.
First off, stocks, unlike ETFs, have a fixed number of outstanding shares. ETFs are also valued based on the price of all their underlying basket of securities. Moreover, because of the way ETFs are structured, authorized participants, or market makers, can create or redeem ETF shares to keep the ETF in line with the net asset value of the underlying basket of securities.
Consequently, when there is a sudden spike in interest for any given ETF, market makers can cushion the price impact by creating or redeeming ETF shares.
The real question potential ETF investors should ask is: how liquid are the underlying components, be it bonds, commodities, currencies or stocks?
"ETFs… are really a wrapper of some other investment," Chris Hempstead, director of ETF execution services at WallachBeth Capital, said in the WSJ article. ETF trading volume and assets under management "are two of the more irrelevant metrics when it comes to defining [ETF] liquidity."
For instance, the First Trust ISE Cloud Computing Index ETF (SKYY) has an average daily trading volume of 43,000 and $77 million in assets. Still, of its top 10 holdings, eight are actively traded stocks with average daily volumes upward of one million shares.
Looking at the ETF universe, investors are ignoring a potentially large number of lucrative investment strategies -- only around 25% of all ETFs in the market trade with over 100,000 shares per day.
Max Chen contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.