Exchange-traded funds have come a long way since they were first introduced 19 years ago, but apparently not far enough, as the majority of ETF assets remain concentrated in a small minority of the available funds.
Although there are more than 1,400 ETFs on the market, more than two-thirds of the trading volume and more than half the assets are linked to just 25 funds.
Ironically, the primary reason for such an imbalance is an overemphasis on trading volume as a gauge of liquidity. As a result, advisers are screening out some of the best-performing ETFs and limiting returns for their clients.
“Clearly, advisers and wealth managers are avoiding some ETFs because they're only looking at the trading volume,” said Reginald M. Brown, managing director of the ETF unit at Knight Securities Group, a trading platform that accounts for nearly 20% of all ETF trades.
What he and others in the industry have come to realize is that a lot of financial advisers are screening out thinly traded ETFs, based on the oversimplified assumption that low trading volume represents a lack of liquidity.
NOT THE BEST WAY
Although trading volume is a traditional indicator of investment liquidity, it isn't the best way to evaluate an ETF.
Doug Sandler, chief equity officer at RiverFront Investment Group LLC, described trading volume as one of the “most popular and stupidest ways to pick an ETF.”
Mr. Sandler, whose firm has half of its $3.2 billion under advisement allocated to ETFs, said that what most advisers forget is that ETF liquidity is based not on trading volume but on the liquidity of the investments on which the ETF is based.
“The mechanics of an ETF is such that you can create more shares, if more are needed, or [eliminate] some if you have too many, and by that token, ETFs are liquid,” he said. “It's about the underlying investments.”
Part of the reason that the liquidity of the underlying investments is important is because greater liquidity will mean a tighter spread between the bid and ask prices, which often are based on the ease with which a market maker can hedge exposure to the underlying positions.
The Direxion Nasdaq-100 Equal Weighted Index ETF (QQQE) from Direxion Funds, for example, tracks as its underlying benchmark the highly liquid Nasdaq-100 Equal Weighted Index.
Thus even though the ETF trades fewer than 20,000 shares a day, the difference between the bid and ask price is just 2 cents.
“We hear quite often from advisers that there is no trading volume, and they perceive that to mean there is no liquidity. But we tell them to look at the spread,” said Mike Eschmann, senior vice president at Direxion, which manages $7 billion, including $6 billion in ETF assets.
Instead of focusing on an ETF's trading volume, advisers should look at the bid-ask spread, the liquidity of the underlying index and the intrinsic net asset value of the ETF, which represents the fair value of the underlying investment and is posted every 15 seconds throughout the trading day, he said.
Armed with that basic information, advisers should be ready to place informed limit-order trades for ETFs, Mr. Eschmann said.
The ETF market is flush with examples of where average trading volume can be a misleading indicator of liquidity.
Consider, for example, the EGShares Emerging Markets Consumer ETF (ECON) from Emerging Global Advisors LLC, which tracks the Dow Jones Emerging Markets Consumer Titans 30 Index.
According to Mr. Brown, even though the underlying stocks represent companies based in emerging-markets countries, they are large enough and liquid enough to allow for easy creation of new shares of the ETF, which has an average daily trading volume of just 125,000 shares.
By contrast, the iShares MSCI All Peru Capped Index ETF (EPU) from BlackRock Inc. has a daily trading volume of nearly 300,000 shares but is pegged to a Peruvian stock market that trades just $15 million a day.THICK AND THIN
“The underlying, in the case of Peru's market, is not very liquid,” Mr. Brown said. “You can't dismiss a thinly traded ETF just because it is being thinly traded, because if you're not looking at the entire universe of ETF offerings, you're not getting the full benefit of what's out there.”
According to Morningstar Inc.'s ETF database, a basic screen based on trading volume would eliminate some of the best-performing ETFs.
Of the 20 best-performing ETFs this year, which had gains in a range between 24% and 44%, 13 trade less than 200,000 shares a day, and nine trade less than 10,000 shares a day.
For perspective, the top 20 ETFs by trading volume trade between 15 million and 214 million shares a day.
“Some investors haven't yet figured out that there are more important things to look at than trading volume, because they still view ETFs through the same lens of 10 years ago, when everything was homogenous, and all ETFs in the same category did pretty much the same thing,” said Ryan Issakaimen, senior vice president and ETF strategist at First Trust Advisors LP.
The firm manages $50 billion, including $7.5 billion in ETFs.
Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com
