Most investors have grown used to the habit of avoiding stocks with low trading volumes; however, this mindset should not be applied to exchange traded funds.
Typically, investors who execute orders on lightly traded stocks will see significant changes when buying or selling the stock, but this phenomena does not occur when trading with ETFs, writes Tom Lauricella for the Wall Street Journal.
First off, stocks, unlike ETFs, have a fixed number of outstanding shares. ETFs are also valued based on the price of all its underlying basket of securities. Moreover, because of the way ETFs are structured, authorized participants, or market makers, can create or redeem ETF shares to keep the ETF in line with the net asset value of the underlying basket of securities. [True Liquidity]
Consequently, when there is a sudden spike in interest for any given ETF, market makers can cushion the price impact by creating or redeeming ETF shares.
The real question potential ETF investors should ask is: how liquid are the underlying components, be it bonds, commodities, currencies or stocks?