ETFs trade like stocks. But a common mistake is to view them as stocks. That comes to the fore when considering average daily volume. Investors are afraid of moving the market against them with, for example, a 1,000 share order.

To be sure, with small-cap stocks or retail-oriented offerings such as preferred shares, investors have to be careful. More than one or two board lots might move the market because these are pools of investors that are too small for institutional investors to play in.

But that’s not the case with ETFs, said market makers at the recent Toronto Exchange Traded Forum sponsored by Radius Financial Education. A focus on average daily volume is to see only the tip of the iceberg.

Behind a thousand ETF shares traded, says Ed Boyd, managing director at RBC Capital Markets, there could be trades of 10,000 to 50,000 in the underlying—the stocks that make up the ETF.

“Liquidity is predicated on the underlying basket,” says Reggie Browne, senior managing director, ETF Group, at Cantor Fitzgerald in New York, which trades $1 trillion in ETFs a year.

Then again, sometimes liquidity isn’t predicated on the underlying basket.

Take an Egypt ETF. It traded every day in New York. But the underlying stock market was closed for three months during the Arab Spring.

If that sounds extreme, it’s still an everyday occurrence in some ETFs. Asian trading hours do not overlap with North American ones. The underlying doesn’t trade. But the ETF does, giving investors a chance to express their views, says Boyd.

So how do market makers make a market? They take a risk—they charge for it—“and run a match book or a correlation book,” says Boyd. In other words, they find reasonable substitutes—and unwind them at the opening of the trading day. Which is why the first 15 minutes of trading is not a good time to buy an ETF.

Scot Blythe is a Toronto-based financial writer.
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