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By Eric Dutram

Although ETFs have begun to surge in popularity over the past few years, there are still a few misconceptions about how the products work. While mistakes are often made when it comes to how to utilize leveraged and inverse funds or commodity and volatility products in a portfolio, another key aspect of ETF investing afflicts nearly all investors no matter the product type; volume.

Volume, or the number of shares trading in a particular period, is regarded by many as the basis for liquidity in the stock world. The more shares that trade in a particular security, the easier it will be to move in and out of it, keeping bid ask spreads tight for popular stocks (see the Three Biggest Mistakes of ETF Investing).

When investors apply this logic to ETFs, the resulting thinking is that high volume funds are extremely liquid while low volume ones, much like thinly traded stocks, should be avoided by most. After all, it is only natural to assume that ETFs are like stocks in this regard as both are exchange-traded and many ETFs are just baskets of stocks anyway.

However, this isn't always true as, unlike a regular stock, an ETF doesn't rely on its actual volume to generate liquidity. Instead, an ETF's volume is dependent on its underlying holdings for its actual liquidity.

Say What?

The above statement is true because of how ETFs are structured and how new shares are created in a fund. Basically, what is called an Authorized Participant (AP) can step in and buy up securities in order to create a new basket of ETF shares, or trade in ETF shares for underlying securities as need be.

Due to this feature, ETFs often trade quite close to their net asset value (NAV), since when prices deviate too far-either high or low-the Authorized Participant can step in to balance the process out. Thus, when ETF prices are too high compared to the NAV, the AP creates more ETF baskets while when the ETF prices are below the NAV, the shares are traded in by the AP for the underlying securities.

The AP profits from the spread differential in this arbitrage-like move, which also helps to keep ETF prices in line with their NAV so that everyone wins in this creation and redemption process (read ETFs vs. Mutual Funds).

Why is this important?

This is key because many investors in ETFs were stock buyers first who are now beginning to see the promise of using exchange-traded funds in their portfolios. Due to being conditioned to apply stock logic to ETFs, many may be unfamiliar with the creation and redemption process and assume that if a low volume ETF isn't trading frequently that it will be unable to be bought and sold regularly and easily throughout the day.

In other words, while stock volume is limited to the float of the particular security, ETF volume is limited to the float of all its underlying securities and the ability of an AP to buy or sell them on an open market. Basically, if an ETF invests in liquid securities, it will generally be easy to trade, regardless of the current volume levels you are seeing.

Take for example the WisdomTree LargeCap Value Fund (EZY), a product that has just $30 million in AUM and volume of just 3,000 shares a day. While at first glance investors might automatically avoid the product, a closer look at the holdings reveals a different story (read Try Value Investing with These Large Cap ETFs).

The ETF's top holdings consist of some of the most liquid and widely held stocks in the U.S., including ExxonMobil (XOM), Apple (AAPL), and Chevron (CVX). All of these stocks trade at least six million shares a day, how difficult could it be to a build a basket with stocks like those?

Caveat to Low Volume ETFs

With that being said, investors should note that low volume ETFs still face some issues that their high volume counterparts do not, namely in the form of bid ask spreads. Low volume funds generally have a wider bid ask spread, a factor that can add to total costs when compared to their more liquid peers.

This also means that limit orders will definitely be necessary for low volume ETFs as well. Since the bid and the ask spread is much wider in these funds, one must set a tight asking price in order to get into a particular security at a good price.

Furthermore, not all market segments are created equal and some will necessarily be more liquid than others. For example, those following large cap U.S. stocks are likely to have an easy time with the creation and redemption process, while those that target niche small cap U.S. stocks may find it a tad more difficult.

The same can be said for (especially) bond products and international markets as well. While these securities are relatively effortless to get your hands on if you are an AP, it is undoubtedly easier for EWC to build a basket of Canadian stocks than it is for IDXJ to find and easily trade in small cap Indonesian securities.

Still, no matter the volumes of these aforementioned funds, similar products tracking like indexes will probably face comparable issues when it comes to creating and redeeming baskets of the underlying ETF.

For example, both the iShares MSCI Russia Capped Index Fund (ERUS) and the SPDR S&P Russia ETF (RBL) follow large cap Russian stocks. However, RBL has a volume that is roughly one-tenth of ERUS, and AUM that is a fraction of its more popular counterpart.

Yet, when one looks at the holdings, the funds are strikingly similar as all of the top three holdings are identical, representing close to 50% of assets for both ERUS and RBL. So although ERUS has a (slightly) tighter bid ask spread and more volume, it is unlikely to be that much more liquid as it is targeting-more or less-- the same securities for its ETF baskets as its more thinly traded counterpart.

So, the moral of the story is that low volume ETFs shouldn't be automatically dismissed from the get-go. While investors will often have to pay a few basis points more thanks to the bid ask spread, the product will still be easily tradable so long as its underlying securities are sufficiently liquid.

As a result, the next time you see an interesting low volume ETF, take a closer look at its holdings and current spread instead of immediately crossing it off of your list. The ETF may not be as off-limits and as impossible to trade into as you may have initially thought before you understood the truth about the low volume ETF world.

Disclosure: long XOM

Source: The Truth About Low Volume ETFs