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Low-volume ETFs are being overlooked by investors for all the wrong reasons. What makes an ETF different than a common stock is that the liquidity of an ETF is not based upon the actual trading volume of any specific ETF. Rather, an ETF's liquidity is determined by the trading volume and shares outstanding of the underlying securities within the ETF's portfolio.

The popularity of exchange-traded funds, or ETFs, is exploding for good reason. ETFs have all the diversification of a mutual fund but can be traded like a stock. You can short an ETF, trade an ETF option, and buy an ETF in the morning and sell it in the afternoon. No way that's happening with your favorite mutual fund.

When you call up the ticker for a popular ETF like SPY, which tracks the S&P 500, you might see a daily trading volume of 11 million shares and think to yourself that an attractive ETF has to have millions of outstanding shares. But say you're looking to invest in a specific sector like Healthcare and you like the looks of a certain ETF that has a daily trading volume of, say, 1,500 shares.

You might say I am not touching anything with that low of a trading volume. And you could be making a mistake. Here's why: As I said before, the daily trading volume of an ETF does NOT represent the liquidity of the ETF. So if your ETF with a daily volume of 1,500 shares is made up of large-cap medical equipment providers, for instance, you're actually buying the liquidity of all those large-cap companies' stocks.

How is that possible? It's all about the structure of exchange-traded funds. While an ETF can be traded just like a stock, it's not really like a stock all. When stocks are traded, huge order volume can drive prices up. The more liquid the security, the safer you are from huge orders that cause prices to spike or dry up all the available shares.

This is where ETFs diverge. ETFs are structured so that any investor, retail or institutional, can execute large orders with no impact on an ETF's price, which is determined mainly by the underlying securities in the ETF's portfolio.

All ETFs have somebody called an Authorized Participant whose job is to create as many shares of the ETF as the market demands. That makes the price of the ETF completely separate from its total shares outstanding. That's also the main reason why a popular ETF like SPY has such a huge trading volume: The more SPY bought, the more shares are issued by its Authorized Participant.

There is one negative about low volume ETFs and that is the typical 5 cent to 7 cent spread between the net asset value and the bid and offer. Investors trading in ETFs should make sure to use limit orders and not market orders when buying or selling shares of low-volume ETFs. Investors of any size, whether retail or institutional, could pay an extra 0.2% using a market order instead of less than 0.1% using limit orders.

So if a huge order hits your favorite low-volume ETF, you don't have to fret about the price doing a moonshot or all the available shares vanishing. The Authorized Participant will simply issue enough shares to fill the order and the ETF's price will be unaffected.

Of course, any ETF will be just as risky as the sector it represents. And certain kinds of securities, especially those traded outside the U.S., can be far less liquid than domestic securities. As with any fund, you have to read the prospectus and consider the liquidity of the shares the ETF purchases.

But you do not have to reject an ETF simply because you called up an online stock quote and saw a low trading volume. In fact, we ran a study recently which showed that low-volume ETFs can perform as well as large-volume ETFs, and sometimes outperform them.

For full disclosure I am portfolio manager of TrimTabs Float Shrink ETF, TTFS, and also CEO of TrimTabs Asset Management, the sub-advisor to TTFS.

In part two you can find out how to measure the performance of low-volume ETFs and greater understanding of how ETFs work.

Pricing of Common Stocks Pricing of ETFs
Determined largely by level of demand and corresponding availability of a company's shares. Determined largely by the basket of underlying securities in an ETF's portfolio. Because an ETF's Authorized Participant (AP) creates as many shares of the ETF as the market demands, the price of the ETF is completely separate from its total shares outstanding.
Liquidity of Common Stocks Liquidity of ETFs
Investor demand determines the liquidity and price of individual stocks. Shareholders aiming to sell shares seek out willing buyers, reducing the price if need be to close the sale. High demand for the stock, meanwhile, pushes its price higher. The AP issues ETF shares if demand outstrips supply, so if shares are scarce in the secondary market when a large order hits, the AP simply creates new shares of the ETF without affecting the price of the underlying shares or the ETF's price.

In part 1 I talked about why there's no need to fear ETFs that have a low trading volume. Now I am going to talk about how to assess the performance of low-volume ETFs.

To summarize, low volume ETFs might have a daily trading volume in the low thousands, compared to popular ETFs like the QQQ, which has a daily volume in the tens of millions. ETFs trade like stocks so investors often think an ETF's daily trading volume is a sign of its liquidity. As we showed last time, that idea is just not true.

An ETF's liquidity is determined by the liquidity of its underlying portfolio of securities, and ETFs are built so that there will always be enough shares available to trade. When large orders come in, new shares of the ETF are issued to meet the demand without affecting the ETF's price, which is set by the fund's underlying portfolio.

The first thing you need to know about trading in low-volume ETFs is that there will be days where they are not traded at all. When this happens, performance calculations are typically based on the closing price on the last day when the ETF was traded.

This produces stale prices that generate inaccurate month-end quotes that can give investors the wrong idea about how well a low-volume ETF has performed. It's far wiser to judge a low-volume ETF by its net-asset value, or NAV.

Even when a low-volume ETF has doesn't have a have a closing price on a particular day, it will always have a closing NAV determined by its underlying holdings.

We used net asset value to compare the performance of 40 low-volume ETFs to 40 of the highest-volume ETFs over the past nine months. We found that low-volume ETFs actually outperformed high-volume ETFs by a small margin over that time period. Admittedly it's a very small time window, but it does show that low-volume ETFs can hold their own against their high-volume brethren.

With all the trading advantages of ETFs, they're bound to become even more popular in the years ahead. Of course you have to do all the due diligence with a low-volume ETF that you'd do for a high-volume fund.

When you're checking quotes online, you need to assess changes in net asset value over time, because these changes track the performance of the underlying shares and give the truest picture of the ETF's performance. When you're checking the prospectus, you have to weigh all the risks of the fund's portfolio, including the liquidity of its individual components.

Trading in low-volume, illiquid securities is not for the faint of heart, but trading in low-volume ETFs is not a matter of being brave. It's a matter of being smart.

Source: Why Low Volume ETFs Should Not Be Avoided