Larry Berman's take on what volume means for ETFs
Diane writes in and asks:
Many of the BMO ETFs that Larry mentions on the show have low volume in comparison to most stocks. Is there a certain volume minimum in which we should be concerned about when purchasing these low-volume ETFs?
Volume is an important consideration for traders. It’s not as important for investors who are holding for long periods of time. This is how I consider volume in ETFs: I think about it like an iceberg. The amount traded on the ETF is a small fraction of the underlying. Actually, value traded is more important than volume. I’m using two examples of BMO ETFs to explain.
The ZEB equal weight bank index (ZEB.TO) is one of the most popular BMO ETFs and has over 1 million shares trading daily on average, with a value of $30 million. Looking at the six banks that it holds on an equal weight basis, you can see the average volume is well over 2 million shares with a value traded of about $250 million. As you can see, about 85 per cent of the value that trades in the underlying stocks daily does not come close to what one of BMO’s most popular ETFs trades.
One of the lowest-volume traded BMO ETFs is the ZJN Junior Natural Gas (ZJN.TO). Over the past three months, it’s traded about 3,000 shares per day or about $61,000. The top six holdings trade about $100 million per day. It’s clear whether you look at the most active or the least active ETFs, the liquidity is more about the underlying securities than the how much trades on a day to day basis.
Volume and liquidity have a direct relationship with units outstanding. ZEB has over 44 million shares outstanding for a market cap of about 1.3 billion. ZJN has about two million shares outstanding for a market cap of about 31.5 million. Implied liquidity is a calculation that looks through to the underlying securities and calculates how easy it would be to create new units. For ZJN, implied liquidity based on the underlying shares is over 4.1 million shares per day and a value traded of over 60 million. For ZEB, implied liquidity is about 5.3 million shares per day with 155 million value traded.
Other considerations around volume remind us market studies have shown that about 70 per cent of all ETF volume that trades does not result in a creation or redemption of units. This means the underlying stocks do not see any volume. ETF unit holders are trading with other unit holders.
For most do-it-yourself investors, you are trading in the secondary markets (that is the number of existing ETFs outstanding) and do not get into creation and redemption of units. But institutional investors like me need to consider the liquidity of the underlying market because I often have to create new units to buy in the size I need to.
Volume is important for individual stocks, but when it comes to ETFs, you need to look through the ETF and consider the underlying. Most ETFs do not invest in illiquid markets. Other considerations are that for emerging market ETFs that are closed during North American hours, the bid-ask spreads are going to be wider because the underlying stocks are not trading. Same is true for European exposed ETFs in the afternoon.
One of the biggest costs of investing is the bid-ask spread (not as important for buy and hold investors). Often, far more important that the fee (commission) you pay to buy and sell. Consider that a one cent spread on a $20 ETF is equal to five bps.
If you want to learn how to make better investment decisions and how to build portfolios that fit your investor type, come out to the current Berman’s Call tour (investor’s guide to thriving). You will learn about some of the behavioural biases that might be hurting your investment returns and learn how a bit more about how to properly diversify your portfolios, which most individual investors do not do very well. Learn how to identify what type of investor you are and some techniques to improve how to manage your asset allocation so you can preserve and grow your portfolio. The events are free and we ask for a voluntary charitable donation to either Sick Kids Hospital or Baycrest Brain Health research for Alzheimer’s. Visit www.etfcm.com or Bermanscall.com to register.