Since ETFs trade like a stock, conventional wisdom dictates that volume is a strong indicator of ETF price movements.
When a stock trades, supply/demand issues can counter fundamentals. News or rumor may be driving demand and volume. Frequently, large volume is an indicator that investors are buying the stock (driving prices up) or dumping the stock (creating a fire sale). This theory does not directly correlate to the ETF world. Understanding the basics of how the two securities function holds a key to how they differ.
How a stock works: a public company, generally through an initial public offering, issues shares comprising a percentage of the overall firm to the public. For instance, if a firm with 100 million shares outstanding sells 20 percent to the public, then the public float is 20 million shares. The shares outstanding are a defined and finite commodity. If there are more buyers than sellers, perhaps buyers will pay more to own the stock, driving the price up. This may be due to an increase in revenue or earnings, or it may be news driven. Anything that increases demand for shares usually causes price increases.
How an ETF works: Unlike the stock of a public company, the number of outstanding shares of an ETF is flexible. ETFs are representative of an index comprised of a pool of securities. The price of the ETF, before fees, should essentially track the index. The value of all stocks that comprise the ETF is referred to as Net Asset Value, or NAV. This term is used across many fund structures.
The market maker has the ability, in partnership with the custodian bank, to create new blocks of ETF shares or, in the event of sales, eliminate blocks of ETF shares in what the industry calls "creation units". As ETF shares are created or retired, shares of stocks that comprise the underlying index are purchased or sold. This keeps the price of the ETF unit in line with its underlying stocks, which track the index. The index itself can be tracked by all investors under its own unique ticker symbol. Its price moves precisely with the sum of its underlying securities.
Trading volume as a barometer: Volume can be an indicator of investor interest or flight. Investor sentiment as measured by volume may be a tell tale sign of the direction of the underlying index. But then again, it may not, as herd mentality is often counter-intuitive. The key takeaway is that the supply/demand of ETF shares is not in itself a factor in the price movement; the value of the constituents in its underlying index is what counts.
Conclusion: When there is demand for an ETF, the market makers simply create more shares. If there are sellers, the market maker will first seek buyers and if there are none they will dissolve the units.
Volume may be a good indicator of the sentiment of an investment thesis but it is not the driver of the ETF price.
Mr. Corn is CEO of Clear Indexes LLC which publishes the Clear Spin-Off Index tracked by the
Claymore/Clear Spin-Off ETF (AMEX:CSD).