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ETF liquidity is one of those topics that always seems to mystify investors. I've seen rooms full of brokers and RIAs nod their heads thoughtfully when listening to speakers describing the ETF creation/redemption process. At some point in the discussion each has their own "a-ha" moment once the speaker ties this process into understanding ETF liquidity. However, once they've left the room you will later hear them talk about how they would never buy the XYZ ETF because of low trading volume. While ETFs can be traded like equities, liquidity is an area in which they are nothing like equities. In this article, I'm going to compare two ETFs from a liquidity perspective. The first is the PowerShares Water Resources Portfolio (NYSEARCA:PHO) and the other is the First Trust ISE Water Index Fund (NYSEARCA:FIW). For full disclosure purposes, I manage and maintain the ISE Water Index (HHO), which is the underlying index for FIW.

If you already have exposure to the water industry using an ETF, the odds are roughly 13:1 that you own PHO based on both fund's assets under management (AUM). Indeed, whenever I talk with investors (retail, broker, RIA or institutional) about investing in the water industry, they all gravitate towards the "most liquid" product, PHO. Even though for the past two years running the ISE Water Index has been among the top ten investment ideas prepared by Morgan Stanley Smith Barney's Global Investment Committee, the majority of asset flow has been to funds that are not based on the index. I have brokers tell me often that they like FIW better than PHO and use FIW's index to track the water industry but "could never" put their clients' money in FIW because of liquidity concerns. Let's take a look at these liquidity concerns.

On February 7, PHO traded 209,448 shares and FIW traded 13,254 shares. The average bid/ask spread for PHO was about $0.02 and FIW's was $0.04. The average investor, which includes me, (50 - 500 share trade, or about $1,000 - $10,000) would look at these figures (especially volume) and write a ticket for PHO confident that he'll get filled quickly and be able to exit his position just as easily. To those average investors using volume as an excuse not to trade FIW I say don't worry about shares traded, drop the ticket. Your trade isn't going to be moving markets in either of these funds. To those pointing to the wider spread on FIW as evidence of some disability, I remind them that the displayed bid and ask are merely quotes, suggested prices if you will, and a fairly priced limit order will reduce or eliminate any spread advantage one ETF has over another. While I am spending some time talking about the trading of these products, I want to remind you that what should be driving your investing decision is not a penny saved in spread or concerns over liquidating a couple of hundred shares sometime in the future. Research these funds; what do they hold, how have they performed, how do the expense ratios compare? Seriously, go check right after you finish reading this.

The heavyweights among you are probably saying, "Well what if I want to trade in size? If I drop a $1 million ticket, FIW will blow up but PHO will just lap up my trade and beg for more." This is where it gets interesting. Let's say you drop a $1mm ticket in both PHO and FIW. Based on trailing 5 day average daily value traded (ADV), that trade is 328% of FIW's ADV but also a not insignificant 30% of PHO's. The point here is that in both cases you (or an authorized participant) are going to go out and put together a creation unit (the basket of stocks equivalent to 50,000 shares of the fund).

Two things happen: 1) as you price out both baskets, you realize that the creation unit for FIW has an average spread that is about a half penny to a penny tighter than the basket for PHO (which is what I've observed intraday over the past few weeks) and 2) you realize that both baskets have certain stocks that exhibit roughly the same liquidity traits which is to say, they are not as liquid as you'd like them to be. So not only do you have a tighter priced basket in FIW, but the liquidity "advantage" PHO has at the fund level evaporates once you get down to the component level. One final (and the most important) thing is that the $1mm invested in each funds' basket of shares amount to less than 1% of the average daily value of shares traded for both baskets. So at the end of the day, you too should feel free to drop that $1mm ticket because your trade isn't going to move FIW either. This observation applies to the smaller whales out there as well ($100,000 - $1mm ticket).

While this may seem like an all out pitch to trade FIW instead of PHO, the bigger point here is that when it comes down to it, ETFs really have two kinds of liquidity. One I'll call top-line liquidity (shares traded, spread), and the other I'm calling "look-through" liquidity which refers to the liquidity of the underlying component shares of the ETF.

This isn't anything new here. ETF liquidity has always been about the liquidity of the underlying components. Anyone who tells you otherwise may not be the person you should be listening to.

Source: A Deeper Look At ETF Liquidity: The Case Of PHO Vs. FIW