Trading ETFs, Liquidity, Depth Are Different

By Carolyn Dion

NEW YORK ( TheStreet) -- Small investors targeting new exchange-traded funds that tout long-term objectives are finding a confusing state of affairs: apparent liquidity coupled with unnerving volatility.

While I've often focused on liquidity as a measure of ETF health, a quick glance at average daily trading volume is not enough to prevent purchases at a premium and disappointing sales at discount.

The new long-term oriented ETFs, such as the First Trust Multi-Asset Dividend Income Index ETF ( MDIV), provide a good snapshot of how apparent liquidity and surprisingly high volatility can coexist.

Launched earlier this month, MDIV's average daily trading volume, 70,000 shares, is relatively robust for a new fund, the type of statistic that generally suggests a level of relative trading ease for the average investor looking to allocate a portion of their long term portfolio to the fund.

An ETF is relatively easy to trade when investors can enter and exit the ETF (buy and sell shares) at a price close to underlying value or NAV. Generally, the presence of competitive buyers and sellers, often reflected by high average daily trading volume, help to keep the trading of an ETF in-line with NAV through the processes of creation, redemption and arbitrage. Competitive buyers and sellers help to keep the promise of the ETF industry: less expensive products sold in real-time trading.

When an average investor has to pay a significant premium to purchase exposure to an ETF (a price higher than underlying value), this promise is broken. The same investor is doubly betrayed if, when looking to sell shares of the same ETF, they find they must sell the majority of those shares at a deep discount.

This story might sound familiar to some ETF investors who have perused a list of recent executions with a feeling of disappointment. It must have certainly felt frustrating for investors trading MDIV last Friday as shares of this seemingly liquid ETF began to diverge noticeably from NAV on low volume trading. After opening at a small premium, it took just 700 shares to dislodge MDIV from underlying value.

In an electronic trading age where bid/ask spreads seem tighter than ever, how can a relatively small buy order in a seemingly liquid ETF produce such a noticeable premium? There's more to liquidity than average daily trading volume and tight bid/ask spreads.

A truly liquid ETF also has depth, a dimension created by active trading participants and market makers "layering" the market with interest at multiple price points on the buy and sell side. This layered interest prevents buy and sell orders from "blowing though" the displayed next best bid or offer and executing at a distant premium or deep discount.

The bad news? Electronic trading and a myriad of new algorithmic models and order types make it hard to gauge the type of true depth that helps to prevent price dislocation. The good news? There are ways for longer-term ETF investors, looking to buy and hold funds like MDIV or unload longer term exposure, to get executions that more closely mirror underlying value.

The key is patience. Investors who want to use market orders should break them up into smaller chunks and enter the orders over the course of the trading day. Limit orders placed near NAV can also be effective. If you only get a partial execution, you can cancel your existing limit order, wait, and re-enter a limit order near NAV for the remaining shares later on.

A complex and continuously evolving electronic marketplace, is making it difficult for many traders to gauge depth. As traders adjust to this environment, it is important for ETF investors -- particularly those looking to gain or shed longer term exposure -- to avoid the type of price dislocation that can make funds a much more expensive investment.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.