The Hidden Costs Of ETFs

The Wall Street Journal featured an interesting piece titled “For some Investors, Night of Living ETF.” Here are some highlights:

Low costs are a selling point for the exchange-traded-fund industry. But more than a quarter of the ETFs on the market are hitting shareholders with high trading costs that escape many investors’ notice.

These ETFs typically have relatively few assets and low trading volume, but they still total nearly $8 billion in assets.

“Individual investors losing out: That’s the risk with this zombie underclass” of ETFs, said Matt Hougan, director of ETF analysis for IndexUniverse.com. “People will have bad experiences.”

Many of these ETFs still are young and may trade more smoothly if they can attract more assets. But many established funds, like the two-year-old, $2.9 million Claymore/Morningstar Information Super Sector Index, still are small. And some of those that have attracted substantial assets, like the $438 million SPDR S&P; Emerging Asia Pacific, still carry significant trading costs.

The ranks of less-liquid ETFs are expanding as money available to seed new ETFs dries up but fund companies continue to roll out new products. Though many funds don’t attract much cash, they are relatively cheap to launch so fund companies will continue to throw products at the wall to see what sticks, ETF analysts said. There are more than 500 ETFs in registration, waiting to be launched.

What concerns me far more than direct costs is low trading volume. Some of the ETFs featured in the ETF Master list of my StatSheet are featured to show all the different types that are available, but that does not make them necessarily a good choice.

Once you have decided on an ETF invest in (via momentum index selection or other criteria), you need to look at volume. For quick reference, I use Yahoo Finance. Let’s say, I want to check out the particulars for QQQQ (in which we currently have positions), I simply go to this link and immediately can see that the average daily trading volume is over 113 million shares, which makes it very suitable even for large block trades.

How much volume should you be looking for in an ETF? To me, the very minimum is about 4 times the amount I am planning to invest. Say, I want to deploy $2 million of clients’ assets, I want to see an average daily volume of at least $8 million. That assures me a fairly smooth fill without too much slippage.

More importantly, looking ahead, the time will come when the trend reverses, and I’ll be heading for the exit door. I want to be able to get out as quickly as I can and with as little of a price concession as possible.

You can only do that by being invested in high volume ETFs. I suggest you use a similar approach by making a quick volume check before entering your order. In a way, investing in a low volume ETF can increase your hidden costs by decreasing your exit price and thereby lowering your accumulated profit or, in some cases, increasing your losses.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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