There exist many misconceptions about ETF’s and this is a major one that I wanted to discuss today. When trying to find the best possible ETF for your portfolio, many different things need to be looked at. One of them is liquidity of course. An important thing to avoid is losing money every time you trade because of the spread.
It Is An Indication But…
Yes, volume is certainly one indicator that you can look at but it would not be the main one. Ideally, you want to trade ETF’s that have very small bid-ask spreads $0.02 or $0.03 at most. The other thing you want is to trade stocks that have a lot of size available at those prices. The spread could be $0.02 but with only 100 shares on each side which would not be good. Why? Because let’s imagine the ETF has the following market:
If you want to buy 1000 shares, it makes a huge difference if you are able to buy it all at $10.02 or if you end up paying some at $10.04. The easiest way to see this if you can’t access pro tools such as Bloomberg is through your broker. You can either ask or look at their online tools.
In many cases, the volume gives you no idea. For example, if you look at 2 ETF’s:
Both track the S&P500 and SPY has many many times more volume. But both have identical liquidity unless you’re buying tens of millions of dollars (maybe even then). Why? Because those that offer to buy and sell VOO are doing it by trading against futures and stocks so I would personally prefer owning VOO which charges slightly less (0.05% vs 0.095%). There are other instances where some ETF’s that almost never trade have almost unlimited liquidity.
What Makes An ETF Liquid?
This is a very interesting question. ETF issuers have brokers that provide liquidity on ETF’s. How do they do it? They calculate the actual value of the fund. If the value is $10.00, they might offer to buy for $9.99 and sell for $10.01. In the case of the S&P500. They would buy the ETF and sell the S&P500 (in a number of ways). That way, the market maker is able to “lock in” profits. It becomes very important for the market maker to be able to:
-easily calculate the value of the fund
-hedge any risk by trading the underlyings
You can imagine how an ETF that has bank loans as underlyings (BKLN) would not be as liquid.
I’m Glad To Help Out
If ever you’d like to find out how liquid an ETF might be, I’d be glad to help out for sure! Just ask me