3 Rules For Dealing In Thinly Traded ETFs

Summary

• It was once commonly thought that you needed a threshold of average daily volume in order to get solid trading execution.
• The volume of the ETF doesn’t matter as much as a volume of the underlying holdings.
• The truly risky funds are those where the ETF is thinly traded and the underlying holdings are esoteric or priced erratically.

I’ll confess that I once fell prey to the stigma that you have to avoid thinly traded ETFs at all costs. They were looked upon like the dark alleys in the seedy part of town. You can go down that road if you must, but you may ultimately regret it in a moment of panic.

It was once commonly thought that you needed a threshold of average daily volume in order to get solid trading execution. Otherwise, you fall prey to thieving market makers who take advantage by blowing out bid/ask spreads on a large order and make you look like a fool.

This was one of my initial concerns when TD Ameritrade switched its non-transaction fee ETF lineup from a bevy of liquid Vanguard funds to a lineup of State Street (STT), WisdomTree, and PowerShares products. Suddenly you are staring at comparable funds, with the caveat they are trading a couple thousand shares/day instead of the millions of shares/day that the largest issuers garner.

Fortunately, there are several ways to overcome this hurdle, and I encourage both large investors and advisors to understand these concepts when dealing in thinly traded ETFs.

1. The volume of the ETF doesn’t matter as much as the volume of the underlying holdings. This was a tough one for me to grasp at first. I thought everything revolved around the price of the fund itself rather than its net asset value. The fact is, if the ETF owns highly liquid securities, it will likely experience solid pricing when you go to buy and sell.

As a real-world example, we just recently purchased a position in the SPDR MSCI USA StrategicFactors ETF (QUS) for clients. It’s a smart beta, multi-factor fund that selects stocks based on quality, value, and low volatility characteristics. Its average daily trading volume is around 10,000 shares per day, which is peanuts in the ETF world. Nevertheless, because its top holdings include mega-cap stocks like Apple Inc. (AAPL), Visa Inc. (V), and Johnson & Johnson (JNJ), we knew that it would track the underlying basket spot-on.

The truly risky funds are those where the ETF is thinly traded and the underlying holdings are esoteric or priced erratically. This is where you can get burned by inefficient pricing or a mismatch in risk behavior during periods of market stress.

2. Your broker is willing to help you out with execution. One of the advantages I had on my side when purchasing QUS is the ETF block trading desk at TD Ameritrade to execute the transaction. They provided us with real-time best bid quotes from several market makers to ensure we were getting the most competitive pricing possible. We were able to pull the trigger on our terms rather than letting the market give us what it wanted.

Advisors should be using these same tools when they are placing a large block of shares (buy or sell) in a thinly traded ETF. Make sure that you contact your broker to help you execute and they will most likely do it at no additional fee. They want the volume as much as you do.

For smaller individual investors, I would recommend a limit order as opposed to a market order. This ensures you get filled at the price you specify (or better) rather than at the whims of the day. If you feel like your bid isn’t getting filled, try calling your broker and see if they can work it out for you. Just make sure you ask for them to waive any exorbitant phone order transaction pricing if the trade goes through.

3. This works best for intermediate to long-term investors. If you are “Tommy Trader” looking to scalp 5 pennies on the S&P 500 with every little twitch in the market, then stay away from thinly traded ETFs. You want the big boys like SPDR S&P 500 ETF (SPY) or PowerShares QQQ (QQQ). The funds that trade like water no matter what the market is doing on any given day. Let’s face it – those traders don’t really care about composition or cost. All they care about is direction and speed.

Those who may be considering a thinly traded ETF should be doing so with the expectation of holding the position for a reasonable period of time. That’s the only way you are going to experience the value, alpha, or other perceived benefits that drove you to choose the fund in the first place. You want to give it time to work given the composition of the portfolio relative to other competitive options.

You also have to be prepared for those weird days when it trades next to nothing. A thinly traded ETF may finish the day at a premium or discount to its net asset value that will true up in subsequent market sessions. Don’t go into histrionics when this occurs and understand that the fund will adjust as necessary to correctly price the basket of holdings.

The Bottom Line

There are many reasons investors may choose to own an off-beat exchange-traded fund, and volume should not necessarily be a disqualifying factor. With proper analysis and trading preparation, you can make a solid investment choice that adds value to your portfolio.

Analyst’s Disclosure: I am/we are long QUS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

FMD Capital Management, its executives, and/or its clients may hold positions in the ETFs, mutual funds or any investment asset mentioned in this blog. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.