Beyond Bulls & Bears


Volume and the Hybrid Nature of the ETF Vehicle

Investors choose particular exchange-traded funds (ETFs) for many reasons, but volume and liquidity are often important considerations. David Mann, our Head of Global ETFs Capital Markets, says the importance of volume may depend on whether one wants to trade the ETF like a stock, or a fund.   

In my last post on taking the time to appreciate ETF liquidity I hinted that there would be further discussion at some point on using stock metrics for measuring the liquidity of a hybrid stock/fund instrument. I must admit, my thinking on this topic has once again evolved.

Hopefully by now, readers of this forum know that when trading larger sizes of an ETF, its average volume does not tell the whole story. My first blog post back in 2016 discussed how ETF market makers can leverage the liquidity of the basket; I discussed how larger net asset value (NAV) trades are not included in an ETF’s average volume (here) and (here). Heck, I have even tried analogies such as restaurant dining and buying mattresses online.

Admittedly, my opinions on ETF liquidity have typically been from the perspective of the lower-volume ETF. To say larger trades cannot be executed efficiently because of a lack of average daily volume is just plain wrong, and I have a briefcase of examples as proof. However, to say that ETF volume has no value whatsoever would also be disingenuous.

So, how should we then think about the importance of ETF trading volume when selecting an ETF? I think a lot depends on whether the investor wants to trade the ETF like a stock, or like a fund. I fully acknowledge that this view is a bit simplistic, but I think it does acknowledge the hybrid nature of the vehicle:

  • “Like a stock” – short holding times (<2 months) and/or use of options
  • “Like a fund” – a long-term investment into a diversified portfolio of securities

As we have seen thus far in 2021, investors do like to “day-trade” stocks, and that includes ETFs as well. This is a slightly different conversation than earlier this year when I discussed internet message boards and whether they could increase an ETF’s volatility. There are now well over 2,000 ETFs in the United States, many of which provide very niche exposures (sometimes with leverage!). Investors who trade in and out of these funds can have holding times measured in days, and when trading that frequently, the average daily volume of that ETF certainly matters.

But as the holding time becomes longer, the ETF’s average volume becomes less and less important since there is so little trading involved with this investment. Trading-related questions should fade, replaced with those on the fund itself. For example, when comparing passive funds of similar exposures, are there lower fee options available given the impact of higher management fees over the long term? When comparing active funds to passive funds, what is the active philosophy that merits investment over the passive equivalent?

I stand by all the comments from my last post about liquidity being there in smaller/newer funds. The slight tweak in my current thinking is acknowledging that an ETF’s average volume certainly does matter for short-term investments. For the long term, not so much.


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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.

ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.


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