Low ETF turnover and AUM may not be as bad as gun shy investors think
When it comes to new ETFs, many investors adopt a “wait and see” approach — specifically, waiting and seeing if the new product will pick up in terms of turnover and assets under management. But as one financial expert notes, judging a fund by those measures may not be the best idea.
“Some investors worry about low ETF trading volume because they feel it implies a lack of liquidity, wrote multi-factor equity model designer Kurtis Hemmerling in a recent piece for Seeking Alpha. “It is important to realize that you cannot make assumptions about ETF liquidity the same as you can a stock.”
Hemmerling explained that an ETF’s true liquidity is not explained by its trading volume, but by its underlying instruments. To illustrate, he used a hypothetical ETF that only trades about US$1,660 in Apple stock per day. Given that Apple stock shares are worth US$166 each, that means the ETF trades only around 10 shares per day.
If an investor were to place a limit order for US$1,000,000 in the Apple ETF, the fund provider would fill the order with any available ETF shares in their inventory, and then buy more shares of Apple — which has an average trading volume of around 38 million, according to Hemmerling — to create additional ETF shares.
“The ETF has the same liquidity as the underlying, although the bid/ask spread might be a bit wider in the ETF,” he said.
He also addressed the fear that a fund with a low AUM may not survive. An ETF de-listing, he said, is not as devastating for shareholders as a company de-listing: in the former scenario, shareholders can get back cash that’s equal to the fair value of the underlying investments.
“Imagine what would happen if the ETF announced it was liquidating and somehow this made share prices drop by 50%,” Hemmerling said. “That means you could buy shares of Apple at $83 (indirectly through the ETF) and then receive $166 in cash when the fund is liquidated. That doesn’t make any sense and is why it doesn't work that way.”
As hot as the ETF industry is, the typical fund can take several years to gain significant traction with individual investors and bigger investment firms. That means waiting for an ETF to build up a good few years of historical performance may not be the best choice.
“Remember that sectors and styles perform in cycles,” Hemmerling said. “If you chase recent performance, you may be buying at exactly the wrong time when a certain style is overvalued and is soon to consolidate.”
Some funds can generate consistent alpha, he acknowledged, but that can’t be determined through several trailing years of price action. Instead, investors should look at the long-term investment opportunity by looking at different aspects of the fund, including the prospectus, the methodology behind it, and the actual drivers of return.
