Many investors have shied away from exchange traded funds with low trading volumes, but do not let the perceived liquidity deter you from a potentially lucrative investment strategy.
Investors who are trading a stock would look at the average daily volume as a guide to how quickly and efficiently they are able to place a trade. If the security’s trading volume is low, large orders may be executed with large bid-ask spreads and affect the market price, diminishing the return of the overall investment.
On the other hand, large orders in ETFs with low trading volumes can still be executed with minimal costs, but investors will have to do a little extra work.
ETFs trade in two distinct markets: the secondary markets that everyone typically monitors on a stock exchange and the primary market where specific Authorized Participants help create and redeem ETF shares.
Everyone should be familiar with the secondary market as it refers to the on-screen, quotable market that we track through price changes on the stock exchange, similar to tracking a company’s stock.
However, ETFs are also traded on a primary market where APs and the ETF sponsor help create and redeem ETF shares for underlying securities or holdings, which occur at the net asset value of the ETF, through so-called in-kind transactions. Specifically, ETFs and other open-end funds are priced based on an underlying basket of assets, or net asset value.
Mutual funds calculate their fair value based on the NAV of the closing price in the underlying market. ETFs, which trade throughout the day like common stocks, will require a different set of indicative values to help reflect the shifting ETF prices throughout the day. The indicative value is an important indicator as it allows behind-the-scenes APs or market makers to arbitrage potential discrepancies between an ETF’s price and that of its underlying net asset value, so that the ETF will more-or-less reflect the value of its underlying basket of securities.
If demand for an ETF outstrips supply, the ETF would show a premium to its iNAV. Consequently, a market maker could step in to borrow shares of stock from an underlying benchmark and put them in a trust to form a so-called creation unit of an ETF, which are then sold to the public on the secondary market, alleviating the premium.
On the other hand, if an ETF shows a discount to its iNAV, a market maker can reverse the process and redeem ETF shares for a basket of underlying stocks.
The creation and redemption process is an important factor that allows large investors to ease into an ETF position.
For example, JPMorgan Diversified Return Europe Currency Hedged Equity ETF (NYSEArca: JPEH) and JPMorgan Diversified Return International Currency Hedged Equity (NYSEArca: JPIH), which began trading early April, are still new and understandably less widely known. Consequently, the two have exhibited low trading activity – JPIH shows an average daily volume of 1,200 shares and JPEH has an average 5,067 shares, according to Morningstar data. [Read: J.P. Morgan Expands into Currency-Hedged ETFs]
Nevertheless, on Tuesday, large trade orders were successfully executed on the two funds. JPIH saw 961,000 shares traded and held $25.6 million in assets under management, but the ETF is only trading at a 0.29% premium to its net asset value. JPIH was up 3.2% at mid-day. Similarly, JPEH saw 970,588 shares traded and held $25.5 million in AUM, but the ETF is only trading at a -0.03% discount to its NAV. JPEH was down 0.1% at last check.
The creation and redemption process helps keep an ETF trading near its NAV and allows large traders to go in and out of what appears to be an ETF with low liquidity. If an advisor or investor is interested in taking large order on an ETF that only trades on a couple thousand shares per day, he or she would contact a broker or authorized participant. The AP would come back with a quote and the investor would pay the broker the necessary commission.[related_stories]