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May 1, 2012

Narrowing Spreads for Illiquids

For ETFs, the Posted Price Isn't Always Right

By James Armstrong

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For some illiquid exchange-traded funds, the price isn't always right. Spreads can be unreasonably wide, luring the less informed to take the bait and accept a price that is far from reasonable. Fortunately, those spreads are slowly narrowing due to competition.

With illiquid funds, the screen does not always match what an ETF is really worth. If a fund rarely trades, both the bid and the offer will be posted by professional trading shops and will be skewed to a premium or a discount. That means spreads can be more than a dollar wide at times.

Bernie Thurston

Even if liquidity is present, it's not showing up in the posted prices. Recent data from Index Universe shows about 1 percent of ETFs have extremely wide spreads that equal more than 10 percent of the fund's value-in some cases almost 50 percent. Though there are relatively few of these extreme examples, more than 10 percent of ETFs still have spreads of 100 basis points or more. The vast majority of those funds have an average daily volume of fewer than 5,000 shares.

Many in the industry are trying to help investors who want access to these lightly traded ETFs but don't want to get soaked every time they buy or sell. Gradually, they are starting to get some of those spreads down to more reasonable levels, though certain funds still have a way to go.

Bernie Thurston, chief executive officer of Delta One Data, which focuses on indexes and ETFs, said that beginning around the middle of last year, ETF spreads started narrowing. He attributed that in part to better data from companies like his, as well as Index Universe, ETFdb and others.

"Due to the explosion in the number of products, I think traders, when they were asked to trade products that they didn't have experience in previously, obviously widened their spreads," Thurston said. "Now, as more and more information becomes available, those spreads will tighten up again."

Particularly with ETFs offered by smaller providers, wide spreads can still be a problem. Thurston said when traders talk about ETFs, the liquidity of the funds is always something they discuss.

But traders should focus more on the liquidity of an ETF's underlying constituents than on the average daily volume of the fund itself, said Rob Glownia, head trader at Richmond, Va.-based Riverfront Investment Group, which has about $3.2 billion in assets under management.

Instead of trading an illiquid ETF, some players will opt to buy the underlying basket, often using a volume-weighted average price strategy across the day. By the market's close, they've bought all the component shares of that ETF and can have an authorized participant facilitate a share creation process.

Such a strategy can subject traders to market risk, but it prevents them from having to pay a premium due to a wide ETF spread.