ETF Liquidity Tiers – March 2009

True liquidity is hard to gauge, especially for ETFs.  For stocks, liquidity is typically a combination of Average Daily Value Traded (ADVT), current market conditions, and the number of shares outstanding.  We cannot apply the same approach to the world of ETFs because the number of shares outstanding is subject to change at any time.

Unlike stocks, ETFs have a creation/redemption process that allows the creation of new shares to meet increased demand.  Likewise, ETF shares can be retired (redeemed) when demand wanes.  This increases ETF liquidity far beyond the level of stocks with similar trading volume.

While the creation/redemption process is a significant factor for ETF liquidity, there are additional items that come into play.  For example, the bid/ask spread of the underlying stocks and whether or not the stock exchange of the underlying stock is open can have a huge impact on liquidity.  Additionally, with more than 800 ETFs, market makers can’t keep up with all of them, so many with lower volume get ignored.

Although it is not an all-encompassing approach to measuring liquidity, using ADVT to divide ETFs into tiers is a reasonable way to gauge relative liquidity among ETFs.  ETFs with an ADVT of less than $1,000 (yes, there is such a group) comprise Tier 1.  At the other extreme is Tier 9, ETFs that trade more than $10 billion per day.  Each intervening tier represents an order of magnitude increase from the previous level.

These liquidity tiers apply only to ETFs and for comparison to other ETFs.  It is not appropriate to compare ETFs to stocks using the same scale because of the differences in liquidity factors described above.

The following table shows each liquidity tier, along with the number of ETFs and the percentage of the ETF population that make up that tier.

ETF Liquidity Tiers – March 2009

Tier	Avg Daily Value Traded (ADVT)	Quantity	%
1	< $1,000	5	0.6%
2	$1,000 - $10,000	40	4.7%
3	$10,000 - $100,000	166	19.3%
4	$100,000 - $1 million	259	30.1%
5	$1 million - $10 million	201	23.4%
6	$10 million - $100 million	118	13.7%
7	$100 million - $1 billion	54	6.3%
8	$1 billion - $10 billion	16	1.9%
9	> $10 billion	1	0.1%
	Totals	860	100%

Note:  this table constructed from data supplied by Premium Data comprising all U.S. listed ETFs and ETNs during the month of February (843 active at the end of the month plus 17 closures during the month).  The data for new ETFs and ETF closures has been pro-rated.

Tiers 1, 2, and 3 are those that with an ADVT of less than $100,000.  ETFs in these tiers often have days with zero volume and are included in my ETF Deathwatch if they are more than six months old.  These three tiers represent 24.5% of the ETFs.

The largest is Tier 4 – ETFs trading between $100,000 and $1 million per day.  More than 30% of the ETFs fall into this category.  Trading levels in this tier are often spotty, sometimes with only a handful of trades per day.  Traders should generally avoid these ETFs while investors should use limit orders.  Combined with the lower tiers, this represents the majority (55.6%) of ETFs.

Tiers 5, 6, and 7 represent increasing volume and value traded.  The bid/ask spreads are supported by deeper volume, and market makers are usually keeping an eye on trading price versus indicative value.  Depending on the size of your trades, market orders become easier for the 373 ETFs in these tiers.

Tiers 8 and 9 represent the best of the ETF world in terms of liquidity.  These are the members of the ETF Billion Dollar Club – the ETFs that garner the lion’s share of ETF trading.  There are only 17 ETFs in this category, fewer than 2% of all U.S. listed ETFs, but they accounted for 74% of all ETF traded value in the month of February.  These are typically the only ETFs where I feel comfortable using market orders.