I recently got a call from a reporter from the financial media asking my opinion on a certain ETF. To her surprise, my comments were much different than she’d heard from other advisors who were just regurgitating the interesting regional story behind the ETF. Basically, a sales pitch. The ETF in question, the Nashville Area ETF (NASH), provides a great case study to explain why ETF liquidity matters.

NASH invests exclusively in companies whose headquarters are located in and around Nashville. It is meant to track an index of Nashville stocks that they created rather than pick the best stocks in Nashville. As you might expect, it is heavily invested in small-cap stocks (small companies).

Liquidity

The ETF has less than $9 million in assets under management and trades an average of only 16,000 shares/day. That’s very light. Still, infrequent but large trading days can throw off averages and give an inaccurate idea of what we can expect. For example, let’s say we have five trading days of 2,000, 3,000, 4,000, 3,000 and 68,000. The average would be 16,000, but the ETF didn’t trade 16,000 shares on any day! The median volume is 3,000, and that’s a lot more like what can be expected most days.

Forgotten expense

The ETF has an expense ratio of 0.49% and you’ll pay another $7-$10 for each trade at a good discount brokerage. A $10 fee to trade is fine, and the 0.49% in internal fees is a little more than I like to pay for an ETF, but it’s not totally out of the question depending on the circumstances. So far, not terrible. But, we are missing something.

The lack of liquidity causes another expense that many forget about, and that is the cost associated with the bid/ask spread. The Bid is the highest price a buyer is willing to pay, while the Ask is the lowest price a seller is willing to accept for it. This definition is a little misleading in practice, because usually the execution price for a market order will be somewhere around the midpoint of the two. It’s about 1 p.m. as I write, and the Bid for NASH is $25.87 while the ask is $26.05. The difference between the two prices ($.18) is referred to as the Bid/Ask spread. I like to see “tight” spreads, so a “wide” spread like $0.18 isn’t favorable. If the spread were just $0.02, it wouldn’t be something we even talked about; that’s just the price of doing business.

The odd thing is that the price at which this was last traded is $25.78, which is lower than both the Bid and the Ask. That trade happened yesterday. Not a single share has traded yet today. Someone who really wants to sell their shares is either going to have to wait and hope, or be willing to accept less. Yet the person who really wants to buy it is going to have to pay a lot more right now than they could turn around and sell it for a few seconds later. You could end up being at the wrong end of the Bid/Ask spread no matter when you trade it. The difference in the last price traded and the Ask is about 1% right now. Even if you are harmed by only 75% of that on both the buy and the sell, that’s 1.5% in “hidden fees.”

Using a limit order helps, but it also gives you a false sense of getting a good deal because the market will still likely have to move for your order to be filled, and that’s the problem.

Misunderstanding

Some will say the liquidity of the ETF doesn’t matter since ETF shares can be created and destroyed. They will also point out that the liquidity of the stocks the ETF invests in is more important. The Bid and Ask should continue to move with the fair market value even if the ETF isn’t trading because the fair market price of the ETF is derived from the prices of the underlying stocks. Even if a large buyer or seller jumped in, the price of the ETF should not jump because of increased demand in it. However, there are underlying stocks. In some ways, what is technically true also may be a bit optimistic in practice.

First, the option to create and redeem shares is usually only available to very large institutional investors because the number of shares required to form a unit is so high. In other words, your only option is to buy or sell your shares on the open market.

Second, NASH is mostly small-cap stocks, which makes things more complicated.  Small-caps are usually much more thinly traded than larger companies. A large order to buy the underlying stocks may cause their price to jump, which in turn may cause the ETF price to jump. Liquidity concerns are now hitting you on two different levels: at the stock level and the ETF level. Limit orders can move the market in an ETF when there aren’t a lot of trades happening and if the market makers aren’t in any hurry to help out. Orders can sit around waiting for someone to take their other ends. This lack of demand can cause problems when trying to sell.

Where and why does this belong in your portfolio?

This ETF is invested in about 28 stocks, mostly small company stocks. A quick look at what’s inside shows me that the top two holdings add up to about 10% of the portfolio, but they are more or less the same holding. Delek US Holdings (DK) is an energy company and Delek Logistics (DLK) is a master limited partnership (MLP). DK is down around 30% year to date while DKL is down around 20%.

Why small companies in Nashville, specifically? Because the city is growing? It’s true that local social, political and economic factors can play a role in business growth. However, stocks need products and services that do well; location is not enough. We wouldn’t buy a failing company that moved its headquarters from Chicago to Nashville just because it was going to save some costs related to overhead. The entire picture needs to make sense.

Wrap-up

I’ve spent more time thinking about this ETF than a team of Certified Financial Planner™ (CFP®) professionals normally would precisely because a reporter asked me about it, which made it a good time to write up a case study.