ETFs Explained, Why Low Trading Volume Isn’t A Deal Breaker

| November 16, 2010 | 0 Comments

I see a lot of strange questions about ETFs.

One question in particular seems to puzzle newcomers to ETF investing. While the question isn’t too strange, the answer may surprise you.

The question goes something like this… “Should I invest in an ETF with low trading volume?”

First off, let’s be clear.  There are more than a thousand ETFs on the market today.  But the really heavy trading is concentrated in a handful of ETFs.

In fact, only 20 or so ETFs have average trading volume of greater than 10 million shares per day.  ETFs like the SPDR S&P 500 ETF (SPY), PowerShares QQQ (QQQQ), and iShares MSCI Emerging Markets ETF (EEM) fall into this category.

Clearly, these ETFs are used by all types of investors, big or small.

On the other end of the spectrum, more than 730 ETFs have average trading volumes of less than 100,000 shares per day.  And nearly 400 of those ETFs trade less than 10,000 shares per day.

With the majority of ETFs trading only thousands of shares per day, are they deserving of your investment dollars?

The simple answer is yes.  Here’s why.

Investors are always asking about trading volume because they’re really concerned about liquidity.  They want to able to buy or sell their shares of the ETF for a fair price.

Here’s the key to understanding ETF liquidity…

Unlike stocks, an ETF’s trading volume isn’t the same thing as liquidity.

An ETF’s true liquidity is based on the liquidity of the underlying stocks in the ETF.  Remember, market makers can create or dissolve shares of the ETF to meet demand.

As long as the stocks an ETF holds are liquid, an ETF with low trading volume can still be a good investment.

But let’s take it another step.

If you’re worried about getting a fair price when you buy or sell an ETF with low trading volume, take a look at the Discount/Premium.  This information can easily be found on the ETF provider’s website.

The Discount/Premium tracks how often, and by how much, the share price of the ETF differs from the Net Asset Value (NAV).

The NAV is simply the market value of all the stocks an ETF owns.  And most ETFs (even ones with low trading volume) usually trade very close to the NAV.

Avoid ETFs with low trading volume and a history of trading at a big discount or premium to the NAV.

These ETFs are bad investments.  You’ll have a hard time buying or selling them at a fair price.

But as long as the share price is close to the NAV, don’t be afraid to trade ETFs with low trading volume.  The market makers will make sure there’s enough liquidity to buy or sell your shares.  And they’re a great way for individual investors to trade the markets.

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Category: ETFs

About the Author ()

Corey Williams is the editor of Sector ETF Trader, an investment advisory service focused on profiting from ETFs and the economic cycle. Under Corey’s leadership, the Sector ETF Trader has become one of the most popular and successful ETF advisories around. In addition to his groundbreaking service, Corey is the lead contributor to ETF Trading Research, where he shares his insights about ETFs and financial markets on a daily basis. He’s also a regular contributor to the Dynamic Wealth Report and the editor of one the hottest option trading services around – Elite Option Trader.

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