When Liquidity Matters in ETFs

Most important: the specialist's role and your holding period.
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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) - Get Report

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)

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)

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.

I have been able to buy other ETFs in between the bid/ask spread by using a "reasonable" limit. For example, if an ETF has a spread of 10 cents, I would place a limit 2 cents below the ask and get filled a good percentage of the time; not so with my trade for DKA.

Things may have changed with DKA since. (According to WisdomTree, the specialist for DKA is Spear, Leeds & Kellogg. I'm not sure if that was the case when I bought in November.) According to

Bloomberg

on March 21, all the shares trading at the midpoint of the session were traded in between the bid/ask spread.

Because of the way markets work and the requirement to post orders to reflect an improvement on either side of the quote, you will get instant feedback from the specialist with either an immediate execution of your limit order or an update in the quote.

In my experience with this, if the first limit order is not executed, you'll need to buy at the offered price (offer is synonymous with ask) in order to get the trade done right then and there.

Should you even care about this? I think it depends on how long you intend to hold the fund in question. If you're an individual investor buying a few hundred shares that you intend to hold for the long term, I'm inclined to believe that a few cents' difference in execution is less important than whether the fund does what you think it will.

As I wrote in November about DKA, I bought the fund when I sold

BP

(BP) - Get Report

because I wanted less volatility within the energy sector and less single-stock risk (see the chart below).

Even if the spread being too wide at the time cost me 4 cents per share, swapping into DKA and out of BP was still the right trade. I chose DKA over something like

iShares Dow Jones U.S. Energy Sector Index Fund

(IYE) - Get Report

thinking it would outperform. While it has not traded higher than IYE, it has been a little less volatile. So luckily it worked out regardless of the 4 cents.

If you are an investment manager and need a large quantity, you have the luxury of buying small pieces of your total position throughout the day and giving all clients an average price, which is how I execute most across-the-board trades.

But for anyone, individual or professional, looking for a short-term trade, I'd say that 3-4 cents is much more likely to be an obstacle. While there is probably liquidity to execute the order without moving the market up a lot, missing 4 cents coming and going on a $25 ETF to be held for just a few days probably would deter me from lesser-traded ETFs.

None of this is really an issue for more popular ETFs such as the

Oil Services HOLDRs

(OIH) - Get Report

or the

iShares Russell 2000 Index Fund

(IWM) - Get Report

.

If this is an issue important to you, you probably should experiment to see which ETFs offer what I'll call friendlier treatment for reasonable limit orders.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider iShares S&P Global Telecommunications Sector Index Fund, WisdomTree International Communications Sector Fund and WisdomTree International Energy Sector Fund to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Nusbaum was long International Energy Sector Fund in client accounts, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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