ETF Investors: Look for Liquidity

ETFs that have more liquid components should theoretically trade closer to net asset value than funds that have less liquid components.
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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


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


(AAPL) - Get Report



(MSFT) - Get Report

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.

A third set of factors, however, have begun to impact the liquidity of particular ETF markets. ETFs stay close to NAV because of the creation/redemption process that is employed by the funds. Recently, creation of

United States Natural Gas

(UNG) - Get Report

was halted, dislocating the price of the ETF from its NAV. (Split Could Set Straight Two Direxion ETFs) Regulators have begun to zero-in on both

leveraged ETFs


Direxion Shares Daily Financial Bull

(FAS) - Get Report

ETF and

Direxion Shares Daily Financial Bear

(FAZ) - Get Report


Liquidity, low fees and access are the promises of ETFs. Investors have flocked to ETFs for their relatively low cost structure and ability to be bought and sold during the trading day. Large spreads and dislocation for NAV break these promises, potentially adding back in the costs that ETF purchasers are seeking to avoid.

Investors seeking to hedge their ETF investments should concentrate on funds with primary market liquidity. Individual investors who may need to buy and sell ETFs during the trading day should consider both primary and secondary market liquidity.

Firms like Schwab are positioning themselves

to take advantage of the influx of interest and assets in ETF products by issuing their own line of proprietary ETFs. As more ETFs join the marketplace, investors should keep an eye toward liquidity and the promises made by the ETF industry.

As originally published, this story contained an error. Please see

Corrections and Clarifications


Don Dion is the publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

Dion is also president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.