Most investors have preconceived notions on low volumes in stocks, but low-volume exchange traded funds may accept large trade orders without causing a significant impact on prices.
In a research note, TrimTabs reveals that low-volume ETFs over the last mine months were able to match, and even outperform, large-volume ETFs. [ETF’s True Lqiudity]
Essentially, most investors assume that the daily trading volume in ETFs is the definitive indicator of liquidity; however, ETFs are created with an innate creation and redemption process that allows market makers, or Authorized Participants, to tap highly liquid underlying holdings and create or redeem ETF shares to mitigate the price impact of any single trade. [In-Kind Creations and Redemptions]
For instance, if demand for the ETF exceeds supply, Authorized Participants issue new shares to meet the new demand – the PIMCO Total Return ETF (NYSEArca: BOND) is a prime example of this mechanism in action, as the fund has ballooned to $2 billion in assets from $100 million but only appreciated 4.4% since it started trading three months back. [PIMCO Total Return ETF Hits $2 Billion Asset Mark]
“ETFs are simply not built that way,” TrimTabs founder and CEO Charles Biderman said in a press release. “Thinly traded securities can be a liquidity landmine, but the same wisdom that protects investors from the perils of low trading volumes is largely irrelevant to ETFs.”
TrimTabs attributes the divergence in flows between low-volume and high-volume ETFs is being exacerbated by three bad habits: First, large financial institutions require a security to have a certain trading volume and market value before they are allowed to trade in it. Secondly, investors are trapped in a familiarity bias where people associated liquidity in ETFs as similar to stocks. Lastly, investors tend to be more comfortable with large, well-known names.
“Investors often ignore low-volume ETFs, mistakenly believing they are illiquid and too risky,” Biderman added. “They’re missing out on a lot of profitable, low-volume funds that are flying under their radar.”
The research firm discovered that the lowest-volume U.S. equity ETFs rose 22% over the past 9 months, whereas high volume ETFs gained 21.5%.
For more information on ETF assets, visit our ETF performance reports category.
Max Chen contributed to this article.