When Liquidity Matters in ETFs

A reader wrote in to ask me about ETF liquidity, saying he was interested in buying iShares S&P Global Telecommunications Sector Index Fund(IXP Quote) because he believed it looked good technically. He was focused on a pop higher, by about 0.66%, at the open Wednesday on what he saw as a 1,000-share trade.

The easiest way for me to start assessing his take on the fund was to look at a similar product for comparison. The WisdomTree International Communications Sector Fund(DGG Quote) opened higher by about 0.5%-1%, so my take was that the move in IXP was nothing out of the ordinary.

Liquidity does appear to be an issue with a lot of ETFs, but the number of shares actually traded is far less important than the specialist's willingness to execute orders. Think of it this way: If an ETF with a wide bid/ask spread has traded only 300 shares today but the specialist will execute a 10,000-share order at the ask price or a penny below, the 300 shares traded prior mean nothing.

Ideally, from the ETF provider's prospective, an ETF should be thought of as accommodative for trading. Providers are hoping to attract both individual and institutional investors, so any perception of an ETF being difficult to trade works against the provider's interest. And because the provider hires the specialist, poor trade executions would seem to work against the specialist's interests, too.

Remember, that's the ideal, which means it's also not always the case in practice. I have written many columns about the ETFs by WisdomTree and am favorably disposed to the firm's methodology; I integrated WisdomTree's International Energy Sector Fund(DKA Quote) across the board in client accounts in November, as I wrote then, and have been very pleased. I have also used a few other WisdomTree funds on a smaller scale for quite a few clients. However, my experience in trying to buy DKA was a poor one.