ETF Investors: Look for Liquidity

Not all exchange-traded funds have been delivering on the industry's promise of liquidity. Nearly 50 ETF products on the New York Stock Exchange last Friday could not draw enough investor attention to trade a single share.

Recently, shares of the thinly traded WisdomTree Dreyfus New Zealand Dollar(BNZ Quote) climbed 8.03% on just under 7,000 shares, but its net asset value fell 0.22%, leaving the fund at a 0.84% premium at close.

Investors seeking to buy and sell ETFs freely in the open marketplace near their net asset value (NAV) should take note. Liquidity measures continue to be important for ETF traders looking to get the best value for their money.

ETFs have two types of liquidity, primary and secondary. Primary liquidity involves the actual liquidity of the fund's underlying basket of securities. Does the ETF own stocks such as Apple(AAPL Quote) and Microsoft(MSFT Quote) or small-cap stocks in Russia? The ETFs that have more liquid components should theoretically trade closer to net asset value than funds that have less liquid components.

Secondary liquidity involves demand for the ETF in the actual marketplace. Are people interested in a particular new ETF or is there a cheaper, better alternative? ETFs that can't drum up much volume will tend to trade further from NAV. This secondary effect can also make an impact when a certain sector suddenly gets hot, and investors rush into a particular set of ETF products. When the trading volume is increased and there is a large number of buyers and sellers, investors will have more access to liquidity than when that sector is quiet.