By Paul Weisbruch
On March 24 of this year, we published an article to Minyanville titled “ETFs With Little Volume But Big Returns which highlighted ETFs and ETNs that have generated eye-opening performance over time but likely suffer from lack of investor interest due to relatively low average daily trading volumes and embedded misconceptions amongst the investing public (on both retail and institutional levels). Since March, has the world of ETF investors (from individuals, institutional funds such as pensions, endowments, foundations, Registered Investment Advisors, Mutual Funds, Hedge Funds, etc.) scrapped the misconceptions that are present in the mindsets of many in regards to effectively trading large volumes in relatively thinly traded products?
We would argue on the whole, the answer is “No”, but strides are being made in the correct direction thanks to continual education about the ETF/ETN product structures from the ETF issuers and effective measures of executing large trades in lightly traded ETFs by ETF centric trading firms. As Matthew MacEachern, portfolio manager of the EAS Genesis Fund (EASIX) advised by Florida based Emerald Allocation Strategies puts it, “ETFs do not require a certain amount of trading volume or average volume to be liquid. Liquidity of the underlying securities in the ETF will determine its liquidity. The Idea that "Volume Rules" is misguided and misinformed.
The good news is that this misinformation can create market inefficiencies which can be capitalized on.” Michael McClary, CIO of Valmark Advisers in Ohio adds, “Execution is much deeper than just trading volume and spreads. ETFs have a complete second level of liquidity, made possible by the ability of ETFs to issue new shares on the fly.” He elaborates, “If they dug a little deeper, I feel that many investment managers would find that many of the trades that they feel are an issue are actually N.O.P., or normal operating procedure.”
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. In terms of this “screening” that seems to occur, Paul Frank, Portfolio Manager of the ETF Market Opportunity Fund (ETFOX) and founder of Aviemore Asset Management based in upstate New York elaborates:
“I don't screen out ETFs based solely on their trading volume. Some funds such as VBK (Vanguard Small Cap Growth) don't have high volumes, but the underlying securities in the ETF are fairly liquid. I put my orders in near the IV price of such ETF's and never use market orders. The main reason I screen out ETFs is because of its underlying securities.”
Below we have listed tables of ETFs and ETNs (not including leveraged and inverse products) that have at least 1 year of live returns data, and that also trade on average less than 50,000 shares daily. Supposing that “low volume” ETFs are those that fall somewhere in between 50,000-100,000 shares traded daily or less, please keep in mind that the line had to be drawn somewhere for this analysis and there are potentially dozens of other products with considerable performance that simply trade more than 50,000 shares daily on average. These products encompass the 6 major asset classes as defined by ETF Database of Equity (Domestic/International), Fixed Income, Commodity, Currency, Multi-Asset, and Real Estate.
In all likelihood, most of these names are unfamiliar to ETF investors on both retail and institutional levels and are likely not utilized in many portfolios for what seems like a flawed and poor reason, lack of trading volume. This said, as investors become more educated on how to optimally trade ETFs/ETNs on both sides of the trade (buying and selling), especially those lacking heavy daily trading volume, portfolios will become more exposed to a wider array of strategies and ideally rein in better performance over time and bring additional diversification as well.
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Upon closer examination of these top performing ETFs/ETNs, we consulted with a number of industry pundits including representatives from prominent ETF issuers and buy side portfolio managers, as well as Michael Johnston of ETF Database, a well known and respected ETF informational website. Johnston had the following to offer in regards to our study:
“The last several years have seen tremendous innovation on the product development front in the ETF industry. As a result, investors now have more options than ever before, including increasingly targeted products and access to increasingly complex asset classes and investment strategies. The industry remains very top-heavy, with a handful of funds accounting for the bulk of assets and trading volume. So advisors who follow rules of thumb and demand a minimum asset level or trading volume miss out on a huge chunk of the ETF universe, including a number of products that offer unique exposure or a compelling investment thesis. Although advisors and individual investors have learned quite a bit about ETFs over the last several years, there are still some misconceptions around the concept of liquidity. Slowly, investors are realizing that historical volume figures are of limited importance, and that the "spontaneous liquidity" possible through the exchange-traded structure makes ETFs very different from stocks, at least from a trading perspective.”
Christian Wagner, CIO of Longview Capital Management based in Delaware and New Jersey, agrees, adding,
“When it comes to [an] ETP's trading volume tells far from the entire story. Some of our greatest alpha drivers in 2010 have been achieved in low volume ETNs like BAL (iPath DJ Cotton ETN), JJC (iPath DJ Copper ETN) and SGG (iPath DJ Sugar ETN). Trading volume and underlying liquidity are distinctly different attributes in these securities. Do the research. Volume scans alone will cause an investor to miss out on some very interesting opportunities. If you were basing a large part of your investment decision on volume you should discount the validity of Berkshire Hathaway A as a viable investment candidate.”
Also addressing low volume ETFs that have been successfully utilized for impressive returns, Michael McClary of Valmark Advisers adds,
“CUT (Claymore Beacon Global Timber) is an example of a security that was near our volume and AUM limits when we first started trading it. However, our ability to efficiently trade CUT has enabled many of our clients to nearly triple their investment in the position.“
The perspective of another investment manager, Michael Paciotti the CIO of Pennsylvania based Integrated Capital Management, addresses these topics as well. Paciotti stated:
“There are many elements to liquidity. While the knee jerk reaction is to evaluate liquidity based on trading volume, this is actually misleading. We’ve seen several high volume ETFs trade at substantial premiums or discounts from NAV while we’ve been able to move rather large dollars into thinly traded ETFs within a penny or two of NAV. It’s really the liquidity of the underlying notional investment that is the driver to liquidity in an ETF. ETFs tracking high yield credit or micro cap stocks will tend to trade at a larger premium or discount from NAV than ETFs tracking treasuries or large cap equities. It’s the arbitrage mechanism that is inherent in the creation and redemption process that keeps spreads narrow independent of volume. That is not to say that volume is irrelevant, it is just less relevant when trading ETFs than it is when trading individual securities.”
John Hoffman, External Institutional Portfolio Consultant at the ETF issuer Invesco PowerShares whom is well known for its fundamental indexing strategies in conjunction with Research Affiliates (RAFI) as well as successful funds such as PHO (PowerShares Water Resources), QQQQ (PowerShares QQQ Trust), and the PowerShares DB family of commodity and currency ETFs had the following to say about where we currently stand in regards to these matters:
“The growth in the ETF product, in terms of the number of products listed, has enabled investors the ability to attain very precise exposures. However, many investors begin their research based on the trading volume of the ETF and screen out the lowest volume products. Trading volume simply reflects how popular an ETF is in the market place and thus may not be the most appropriate metric to begin your selection process with. If you were in the market for a high performance sports car, you would not begin your selection process by isolating the best selling vehicles. Instead you would screen on metrics that align with your requirements such as horse power or how fast the car can go from zero to sixty.
In the case of the ETF, investors need to begin their research by looking under the hood of the ETF. An ETF's performance is not based on how popular the ETF is in the market place, but rather it is based on how the securities in the portfolio perform. Similar to how you would select a car, begin your ETF research by looking at the engine which in the case of the ETF is the index and the securities that comprise the ETF. Look at how they are weighted, how many securities there are in the portfolio, how they are selected and when do they change. For example, one retail ETF may be highly concentrated in the largest retail stocks, while another retail ETF may provide exposure to small or midcap retailers.
Since an ETF's liquidity is derived from the underlying basket, if your research points to an ETF with low volume and you are size buyer / seller, firms like S1F can help you source the liquidity and efficiently trade the ETF.”
Sara Grillo, principal at New York based Diamond Oak Capital Advisors, took our study a few steps further and presents her own list of prototypical “low volume ETFs” with considerable year to date performance. She notes VSS (Vanguard FTSE All World Ex-U.S. Small Cap) up 21.35%, FVD (First Trust Value Line Dividend) up 13%, PAGG (PowerShares Global Agriculture) advancing 13.99%, FNI (First Trust Chindia) up 15.89%, PXR (PowerShares Emerging Infrastructure) gaining 21.87%, GRU (Elements MLCX Grains Total Return ETN) up 20.84%, FUE (Elements MLCX Biofuels) which has rallied 31.06% this year, and finally IDU (iShares DJ U.S. Utilities) which is up only 3.4% YTD, but also boasts a 3.75% yield. Grillo adds:
“Many ETFs which trade with smaller ADV are what we would consider sector funds which focus on a sector of the market. Typically they would be used to accent a particular feature of a portfolio rather than comprise a large part of it. For example, IDU may trade at an average of 40 or 50k shares per day, but because it is a utility-focused fund, it would never be a core holding anyways. Its best use would be as a “satellite” position comprising 2 to 5% of the total portfolio. Advisors may use a thinly traded ETF such as IDU sparingly for yield enhancement.”
Another ETF issuer, well known for its dividend and earnings weighted strategies as well as its successful line of internationally focused and currency based ETFs, is WisdomTree. David Abner, Director of Institutional ETF Sales And Trading and also the author of the informative “The ETF Handbook” offered the following perspectives on how he sees the evolution in trading ETFs, particularly low volume ones, panning out.
“People are starting to move down the curve and when looking at the details, people are moving beyond the top 30 funds (in terms of AUM size) as far as adding them to their portfolios. They are embracing the broader universe of funds, with less average daily volume, that may give them an opportunity to add alpha to their portfolios. Others, who have not learned that trading volume is not an effective screen, are unfortunately missing out. WisdomTree focuses on ETF trading education across a number of channels that make up the base of ETF users. For instance, WisdomTree works closely with institutional consultants and their clients (such as endowments, foundations, pensions, tax exempt organizations, etc.) in order to educate them on the mechanics of ETF trading. That said, WisdomTree has seen a high level of success across the institutional market with this client base evaluating our methodologies after learning to effectively trade our ETFs. Similarly, on the Wirehouse/Broker-Dealer level, we note that the trading systems and procedures have become more efficient and robust, leading to improved execution for financial advisors across the country in satellite offices who may rely on their firm’s central trading desks, which is a move in a very positive direction from where we were a few years back.”
Another interesting dynamic that Street One has noted is the phenomenon of asset inflows to VWO (Vanguard Emerging Markets) from EEM (iShares Emerging Markets) in 2010 largely due to investors becoming more comfortable with the liquidity and trading aspects of VWO, as well as it’s favorable live head to head performance. This phenomenon seems to have actually helped one of WisdomTree’s products DEM (WisdomTree Emerging Markets High Yielding Equity) because it has produced performance that has trumped both EEM and VWO (DEM up 17.85% in the trailing one year period vs. EEM up 12.80% and VWO up 15.50% during the same period). Thus, just as investors have become more comfortable trading VWO even though it has less trading volume than EEM, they have likewise embraced DEM after learning how to trade it more efficiently due to our ongoing education, and they have realized the benefits of an alpha generating strategy in their portfolios.
In speaking to Richard Kang, Chief Investment Officer of Emerging Global Shares, an ETF issuer focused on emerging markets ETFs with notable funds including SCIN (Small Cap India), BRXX (Brazil Infrastructure), CHXX (China Infrastructure), and ECON (Emerging Markets Consumer) we learned that the issuer is generally very conscious of the underlying liquidity in the indexes that they base ETF products on during the product creation stages. Specifically, Kang noted that Emerging Global Shares realizes that if they create an international sector based ETF that owns strictly emerging markets equities, that they may consciously screen out certain names in those sectors or markets, because they do not want to run the risk of the bottom half of an index having underlying liquidity problems. Kang noted for example that a certain ETF may have only 30 underlying names in their index as opposed to say 100 because as an issuer they do not want to include equities that themselves may have specific liquidity problems, and it provides some level of assurance that the equities that make up the index are large cap if not mega cap names.
Adam Patti, CEO of IndexIQ, an ETF issuer known in the industry for their “Rules Based Alpha” philosophy which “combines the benefits of traditional index investing with the alpha potential sought by active managers” also had some points to offer us for this article. Specifically, Patti stated,
“One of the key themes we hear out in the field speaking with advisors centers on ETF “liquidity”. Given a lack of proper education early in the development of the ETF market, many advisors are still under the impression that their ability to efficiently buy or sell a given ETF depends on the trading volume of that ETF. As we explain to advisors every day, this is absolutely false. I understand why advisors may believe this, particularly given the bloggers and other pundits in the market railing against “illiquid” ETFs. ETFs are not individual stocks. The liquidity of an ETF is 100% based on the liquidity of its underlying holdings. If the portfolio components of any ETF are liquid, then the ETF is by definition easily tradable, both on the buy and sell side. If the index upon which the ETF is based is of high quality and has appropriate liquidity screens then an advisor will never have a problem. Given that ETFs are not individual stocks, there are certain things advisors should be aware of; for instance, always set limit orders when buying ETFs, regardless of its trading volume. Additionally, when buying big blocks of any ETF it is often more efficient to work directly with an Authorized Participant or other liquidity provider. This is because, unlike individual stocks, ETFs can be created on the demand of an advisor; meaning that new shares of the ETF will be constructed and provided directly to the advisor typically at or close to the NAV. This process works exactly the same when advisors are selling blocks of shares.
Given the widespread misunderstanding regarding the trading of ETFs, many advisors actually view buying the less “liquid” ETFs as a competitive advantage. This is because many of the newer or more sophisticated ETFs that have come to market are still trading at relatively low volumes yet are often of higher quality from an investment perspective then some of the older and more “liquid” issues. Understanding how ETFs trade and not getting scared off from buying some of these newer ETFs can offer an advisor’s clients access to exposures that provide a better constructed portfolio, perhaps better than other advisors who stick with the more plain vanilla, older ETFs in the marketplace.
An example of this is our IQ Global Resources ETF (GRES). GRES is the broadest natural resources/commodities ETF in the marketplace and is based on an index with over three years of track-record. Yet given that the ETF has only been on the market for 14 months, it is not as well known as some of the other products in the marketplace. Thus GRES’s trading volume is a fraction of some of the competitive products. Yet investors who have understood that lack of trading volume is irrelevant and purchased GRES have been rewarded with significant outperformance, lower volatility and broader natural resources exposure versus the competitive ETFs. Our IQ Taiwan Small Cap ETF (TWON) is another example. This is the first ETF to provide exposure to the small cap segment of the Taiwanese economy. The product has very low trading volume, yet performance has been absolutely stellar since the fund has launched. Investors who have purchases this ETF have certainly been pleased with the result.
My message is simple, pick the best product to serve the needs of your clients, don’t worry about trading volume - it is irrelevant.”
At Street One Financial, being involved in the ETF trade execution space as a liquidity provider for end users such as institutions, RIAs, and Broker/Dealers, we believe that 2010 marks the beginning of a turning point for the industry as a whole, mainly attributable to ongoing education by the ETF issuers, trading firms, and informed investment managers who have been successfully building portfolios of ETFs/ETNs in some cases for more than a decade. Also, it generally only takes a successful trade or two in a “low volume” ETF for one to dispel embedded myths and misconceptions, and open up new horizons of opportunity within one’s portfolio. An ETF trade execution firm/liquidity provider is only a phone call, an email, or simply an Instant Message away, and as Michael McClary of Valmark Advisers puts it, “Execution specialists are the oil that makes the ETF engine run”.
2011 comes to us with a multitude of newly launched products, and dozens more on the shelf awaiting their launches, with many of these funds more esoteric in their investment strategy than the next. That said, removing the “blinders” when it comes down to screening potential products for inclusion in investment portfolios will be more crucial going forward in order to objectively evaluate the landscape. Portfolio managers and investors alike need to be open minded in the ever expanding universe of ETFs/ETNs, and more importantly understand how to execute their ETF/ETN orders effectively. In doing so, they can avoid missing or intentionally avoiding funds like some of 2010’s winners that we have cited in this report, and can instead add alpha to their portfolios and transform their practices through more efficient and effective trade execution.
Footnote: Paul Weisbruch is the VP of ETF/Options Sales and Trading at Street One Financial, a leading ETF liquidity provider and trade execution firm. www.streetonefinancial.com
Disclosure: Clients of Diamond Oak hold IDU and VSS. Sara Grillo holds VSS.
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