Volume is not the Best ETF Liquidity Indicator

Volume has long been considered an important indicator for making buy and sell decisions with individual stocks. For example, a stock that breaks out of a range on unusually large volume can be telling investors a new uptrend is starting.

Likewise, a stock that suffers an unexpected decline on above average turnover can be signaling that more downside is on the way. While there is long-standing efficacy for volume as an evaluator of single-stock evaluation, volume loses merit as a gauge for measuring ETF demand.

Too often, traders and investors, even some professionals, focus on an ETF’s on screen volume as a measuring stick for the fund’s underlying liquidity. What matters is the liquidity of the ETF’s underlying holdings.

“Without trading, how is there price discovery? Does the ETF share price drift away from its net asset value (“NAV”)? Based on the liquidity of the underlying components, when the bid/ask spread of the ETF drifts too far from the net asset value, market makers and authorized participants will step in, buy or sell the underlying security basket, create/redeem shares with the ETF directly, and collapse the pricing discrepancy. So despite low trading volume, the ETF will closely track index price changes. Hence, volume of the ETF in this case has little-to-nothing to do with price changes in the index it tracks,” notes Newfound Research Chief Investment Officer Corey Hoffstein in a post on Forbes.

The value of ETFs come from the value of the securities that underlie them. Underlying securities have values that are determined in an outright market, and the ETF’s value is expressed in relation to those securities.