By Ajay Makan in New York
Trading in the most popular US exchange-traded funds fell to multiyear lows in January, threatening to increase transactions costs for retail investors.
ETFs, which track the performance of a basket of securities such as an equity or bond index, have surged in popularity in recent years, reaching $1tn in assets by the end of 2011, according to BlackRock.
A key part of the ETF appeal has been liquidity. High trading volumes have made it cheap and easy to trade in and out of the funds. But, according to data from FactSet, daily volume in the 50 most traded US ETFs in January was at its lowest, excluding the last month of the year, since the end of 2007, when the industry was much smaller.
That has increased trading costs in some smaller funds. For example, the average daily spread – the commission market makers charge investors to trade securities – for the US Natural Gas Fund on NYSE’s Arca exchange, was 0.17 per cent in January. That compared to an average spread of 0.11 per cent in the preceding six months.
“Volumes have to be one of the key considerations for any ETF investor: if liquidity dries up, trading costs could increase,” said Bryce James, chief investment officer at Smart Portfolios, a Seattle-based money manager, which invests exclusively in ETFs. “It’s important to be selective about what products you use.”
The fall in ETF trading volumes has coincided with a decline in volatility and correlations in January, compared to their elevated levels in the second half of 2011. That appears to have made index-based investing strategies, which can benefit if an entire asset class moves in the same direction, less popular.
“As correlations and volatility have come in, some investors are tending towards stockpicking strategies instead [of ETFs],” according to BJ Prager, head of Americas exchange-traded product trading at Barclays Capital.
However, the fall in ETF volumes also appears to be a result of reduced trading by hedge funds, which are among the largest users of ETFs. According to JPMorgan analysts, macro hedge funds in particular have retreated from the market in January.
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Sign of extreme complacency