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Investors who are concerned about the ability to exit a position, as well as to enter a position, and particularly those who use stop loss orders, should be aware of and concerned about the liquidity of the stocks they purchase.

We believe that it is unsound to own more than 1% of the average daily Dollar trading volume of any security. We prefer to own less than that — preferably 0.5% as a limit.

Consider that if there is a rush to the door, the greater your position size relative to average daily Dollar trading volume, the more your position will move the market. In a rapidly declining market, limit orders don’t help too much if the market keeps falling below your limit.

Consider that if you use stop loss orders, they become market orders when triggered. A market order in a thinly traded stock, or one that is thin relative to your position size, could result in a quite adverse price upon execution.

The table below shows the average daily Dollar trading volume for the S&P 500 ETFs, and ETFs for its ten sectors, and for several fundamental versions of the S&P 500. (Click to enlarge)

You can see from the table that SPY is more than liquid enough for just about any investor, with $216 million being about 1% of average daily Dollar volume.

We are quite interested to see volume growth in the fundamental S&P funds, because we prefer not to be stuck in the market-cap weighted universe.

However, if you have a $10 million portfolio, for example, and you want to put 10% of you assets in one of these funds, then S&P Growth, Value, Equal Weight, and Dividend Aristocrats, as well as Telecom and Sector Equal Weight are too thinly traded for you.

Clearly, for a very large account, SPY is much superior from a liquidity perspective than IVV -- 40+ times as effective actually.

Fundamental S&P Funds Outperforming:

The fundamentally weighted S&P funds are fairly new, but some have had a very nice showing. The equal weighted and revenue weighted funds have done the best, as shown in the following YTD and 1-year daily percentage performance charts.


The equal sectors ETF is not included in the 1-year chart, because it hasn’t been around that long yet.

These funds deserve watching. When and if they meet your liquidity requirements, they could be attractive additions to a portfolio.

US Market-Cap ETFs Liquidity:

Using the same logic, looking at the table below of market-cap oriented US stock funds, the Dow Jones-based series just is not mature enough for safe use.

The MSCI-based series is OK for most investors, but only SPY, IWM, MDY are good for very large accounts seeking large-cap, mid-cap and small-cap exposure separately through ETFs.

The Russell 1000-based ETF will work for accounts up to perhaps $5 million in size, assuming something like a 20% allocation might be sought — up to a $10 million assets account, if a 10% allocation is sought).


Broad or Total US Market ETFs:

If you seek a single fund solution for the US stock market, and you want to cover all the market-caps, and the growth and value styles, you don’t have very many good choices in terms of liquidity, and no choices among ETFs for accounts greater than perhaps $6 million in size (assuming something on the order of a maximum allocation of 20% to US stocks — even lower maximum portfolio size if the US total stock allocation exceeds 20%).

If you need to have a single fund exposure to the US markets and want to cover essentially the entire market in a balanced asset allocation, and your portfolio is several millions (perhaps $5 million), then your practical option is mutual funds, not ETFs. Mutual funds have to redeem you at NAV at the end-of-day price.

Mutual funds don’t give you intra-day exit potential and broker and mutual fund companies don’t offer stop loss order contingencies. We solved most of that problem for ourselves by developing an in-house trailing percentage “stop alert” system, that tracks the price of any stock or fund each day, and then notifies us by email after the close if and when a security hits the trailing stop trigger price. The next day, we manually exit.

If your portfolio is big, you may well find that mutual funds must be part of your mix, and that many or most ETFs are not liquid enough for your portfolio.

Make sure you include a liquidity analysis as part of your security selection process when you set up and maintain your portfolio.

Securities Listed in Table Images:


Holdings Disclosure:
As of March 18, 2010, we hold SPY, MDY, IWM , SDY, VTI, and XLU in some, but not all managed accounts, We do not have current positions in any other securities discussed in this document in any managed account.

Opinions expressed in this material and our disclosed positions are as of March 18, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.