It was once commonly thought that you needed a threshold of average daily volume in order to get solid trading execution. Otherwise you fall prey to thieving market makers who take advantage by blowing out bid/ask spreads on a large order and make you look like a fool.
This was one of my initial concerns when TD Ameritrade switched their no-transaction fee ETF lineup from a bevvy of liquid Vanguard funds to a lineup of State Street, WisdomTree, and PowerShares products. Suddenly you are staring at comparable funds, with the caveat they are trading a couple thousand shares/day instead of the millions of shares/day that the largest issuers garner.
Fortunately, there are several ways to overcome this hurdle and I encourage both large investors and advisors to understand these concepts when dealing in thinly traded ETFs.
1. The volume of the ETF doesn’t matter as much as the volume of the underlying holdings.
This was a tough one for me to grasp at first. I thought everything revolved around the price of the fund itself rather than its net asset value. The fact is, if the ETF owns highly liquid securities, it will likely experience solid pricing when you go to buy and sell.
As a real-world example, we just recently purchased a position in the SPDR MSCI USA StrategicFactors ETF (QUS) for clients. It’s a smart beta, multi-factor fund that selects stocks based on quality, value, and low volatility characteristics. Its average daily trading volume is around 10,000 shares per day, which is peanuts in the ETF world. Nevertheless, because its top holdings include mega-cap stocks like Apple Inc (AAPL), Visa Inc (V), and Johnson and Johnson (JNJ), we knew that it would track the underlying basket spot-on.
The truly risky funds are those where the ETF is thinly traded AND the underlying holdings are esoteric or price erratically. This is where you can get burned by inefficient pricing or a mismatch in risk behavior during periods of market stress.
2. Your broker is willing to help you out with execution.
One of the advantages I had on my side when purchasing QUS is the ETF block trading desk at TD Ameritrade to execute the transaction. They provided us with real-time best bid quotes from several market makers to ensure we were getting the most competitive pricing possible. We were able to pull the trigger on our terms rather than letting the market give us what it wanted.