From the October 2010 issue of Investment Advisor • Subscribe!

What Trading Volume Says About ETFs

Trading volume doesn't necessarily equal liquidity.

By now, advisors and even most investors understand the way exchange-traded funds (ETFs) operate. One issue, however, that seems to be a cause of confusion is the role of trading volume.

Trading volume has always been the yardstick to measure the success of any exchange-traded financial product, and ETFs are no different. It was the spectacular growth in trading volume of the earliest ETFs which inspired fund sponsors to create new ETFs, several of which are now volume leaders themselves.

So let's take a look at ETF Trading Volume 101. First, there are really two worlds of ETFs: The 20 largest ETFs together account for about 80% of total ETF trading volume, and the roughly 800 others account for only 20% of ETF trading activity.

With trading volumes equal to or greater than some of the most actively traded stocks, and ETFs accounting for about one-third of all equity trading volume as of mid-2009, according to Index Universe, there is little question that some ETFs are liquid enough for any type of investor, and most ETFs are liquid enough for every investor. Take August 26, 2010, a day on which bid/ask spreads at Vanguard varied from as little as 0.01% of the share price for the Short-Term Bond ETF (BSV) and the Total Bond Market Fund (BND) to a high of 0.36% for the Long-Term Corporate Bond ETF (VCLT). There are dozens of ETFs, however, that trade less than 1,000 shares a day, which may have fairly wide bid/ask spreads on any given occasion.

Trading Volume Doesn't necessarily Equal Liquidity

While trading volume is usually thought of as synonymous with liquidity, that is not always the case with ETFs. According to an article from ETF broker-dealer Fox River Execution (now part of Wayne, Pennsylvania-based software firm SunGard) in the March/April edition of Journal of Indexes, the trading volume of the underlying securities of the ETF can be just as important, with the ETF's "true liquidity" being a combination of both.

Unlike stocks, ETFs are priced both through a bid/ask spread as well as in relation to the fund's net asset value. While the fund's authorized participants stand ready to buy and sell shares in the ETF if they move far enough away from the fund's net asset value to make such a trade profitable, there may be significant mispricing before the arbitrage opportunities open up, according to the article.

Many ETFs act to limit this problem by tracking indexes that require specific trading volumes. Otherwise, the Fox River article recommends comparing an ETF's quoted price to its indicative net asset value, which is published every 15 seconds by market data providers. That can be imperfect, though, since indicative net asset value relies on the price of the last trade, which may not reflect current market conditions for infrequently traded issues. Click to Enlarge

S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_Scully@standardandpoors.com. Send him your ideas for ETF story topics.

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