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) 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) and Microsoft ( MSFT) 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) 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 like Direxion Shares Daily Financial Bull ( FAS) ETF and Direxion Shares Daily Financial Bear ( FAZ). 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.