More on ETF Trading Volume

Below is information from Chris Hempstead of Wallach Beth, talking about why the liquidity of the underlying securities of an ETF are the real factor to determine ETF liquidity (regardless of the ETFs average trading volume).  We will have more on this topic in the coming days.

(from Chris)

Now let’s address Average Daily Volume:

Why not start with another top 30 stat? Twenty of the top thirty performing ETFs year to date have ADV below 250k shares.

This is the one that really gets my attention, mainly because ETF ADV is nota true measure of the liquidity of the underlying assets and by default, the actual ETF.

In its most basic form, simply looking at ADV and dismissing a fund based solely on that metric might steer you away from funds that are quoted in block size at the minimal increment (one penny).

Here is an actual ETF example:

The First Trust REIT ETF [FRI], has an ADV of [roughly] 100k shares per day. The quote in this name however, is also roughly a penny wide with 75k shares on each side of the market. This means you can trade roughly 75% of the ADV in a single trade with little or no impact to the quote.

This kind of liquidity (as a % of ADV) is rare in single stock names. Unfortunately, I suspect that the aversion to trading ETFs with low ADV stems from the realities that exist in single stock trading which, again, is just not true for ETFs.

Recently, there has been regular chatter about a metric called ‘implied liquidity’. This is an important step in educating investors as to why they can effectively trade more than just a small % of an ETFs already low ADV. That being said, this metric has many variations and assumptions which need to be considered when ascertaining whether or not the desired investment size can be efficiently executed in a particular ETF.

One other reality in trading low-ADV ETFs that every investor should keep in mind is that because an ETF has less volume and in many cases is less widely held, you are likely to be trading against a professional market maker.

Traders make markets in ETFs based on the funds real time NAV (aka INAV),not last saleLast sale is one of the most irrelevant metrics in determining the ‘right’ price to enter an ETF order.

Knowing how and where liquidity might exist based on a fund’s NAV is the most important tool in efficiently sourcing block liquidity in low-ADV names at minimal premiums/discounts to the ETFs’ NAV.

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