TimingCube - ETF liquidity - ETF liquidity, illiquidity of closed-end funds and exchange traded notes, illiquid CEFs and ETNs

Current Signal Performance as of

Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500

Market Update

It has been a very volatile week for stocks. While U.S. markets were closed Monday in observance of Marting Luther King Jr. Day, other world stock exchanges tumbled on fears of a U.S. recession. As the global sell-off did not show any sign of abating, U.S. markets opened sharply lower Tuesday, but were able to recoup most of their losses by day's end thanks to a surprise Federal Reserve rate cut. Trying to show its willingness to act to avoid a major economic downturn, the Fed slashed the funds rate by three-quarters of a point to 3.5%, the largest rate cut since 1984. With Both Apple and Motorola disappointing investors with their latest earnings reports, stocks gapped down again at the open Wednesday, but were able to snap back to close higher on the day. As the quick turnaround occurred on heavy volume, it can in part be attributed to short-covering as it is likely that some of the same investors that were shorting in the morning bought back in the afternoon. Buoyed by news that a deal had been reached between President Bush and the Democrats on a $150 billion economic stimulus package, stocks were able to move higher Thursday. After the close, Microsoft reported quarterly results that exceeded analysts' expectations. The news gave a boost to the markets at the open Friday, but the gains could not be sustained as all major indexes reversed course to close with significant losses instead.

For the week, the Nasdaq 100 lost 2.98%. The S&P 500 and Russell 2000 did better, posting respective weekly gains of 0.41% and 2.29%. All three indexes remain located well below their 200-day Exponential Moving Average (EMA).

For its part, Our World Index Ranking portfolio lost 1.73% on the week. The portfolio consists of the 5 top-ranked world indexes as of January 4, which marked the beginning of the current 4-week holding period. Please note that since we now have an active Sell signal, the World Index Ranking approach calls for selling your holdings if you follow the "Long Only" or "Long and Short" strategy. Only if you follow the "Buy and Rebalance" strategy should you remain invested in the top 5 indexes, as the strategy calls for staying invested at all times. Please go to our "Strategies" page for all the details.

Our current Sell signal remains in effect.

Trend Timing School

ETF liquidity

We have always loved the convenience, diversification, liquidity, transparency, and low cost of the ETFs which form a cornerstone of our service. In view of recent concerns and issues with the liquidity of certain exchange traded funds, maybe we should be a lot more specific and spell out more clearly that we do not mean just any ETF, but the index-based and open-ended variety of ETFs. To understand how the liquidity of such true ETFs is really the combined liquidity of the companies in their underlying stock market index, and why this is not the case for closed-end funds (CEFs) or exchange traded notes (ETNs), we need to briefly review how ETFs are created and unmade.

It is true that a simple comparison between the large U.S. index ETFs and some of the newer and much smaller country ETFs can be shocking. Take the QQQQ for example, with $20 billion in assets and an average of 180 million shares traded daily, and stack it against the average country ETF at $200 million in assets on average and a few hundred thousand shares traded per day. With such low liquidity, are these investment vehicles really safe to use? The answer is, for most of them a qualified yes.

Liquidity is measured by the daily trade volume expressed generally as the number of shares per day. Thinly traded equities on the other hand are called illiquid and normally have high spreads and volatility. The spread is the difference between a security's bid and ask prices. When there is little interest and low trading the spread increases causing the buyer to pay a price premium, and the seller to be forced into a price discount in order to get it sold. This is how liquidity works for most things, but not ETFs.

Unlike most equities which are issued in fixed quantities, ETF shares are dynamically created and unwound in function of demand which makes them immune to certain aspects of illiquidity. So-called market makers, generally large brokerage houses, can create and redeem shares of the ETF by assembling them from the shares of the companies in the index it tracks. Thanks to this, the price of an ETF is primarily set by the price of the companies in the underlying index, and the liquidity of an ETF is not related to its daily trading volume but rather to the liquidity of the stocks

A key market force that keeps ETF spreads small (generally less than 1%) is that the market makers, specialists, and arbitrageurs all interact and compete to effectively flatten the premiums and discounts to fair market value. They trade ETFs and index futures for profit to exploit any value spread developing between the fund and the index, and in so doing keep the spread of ETFs very small. This fundamental market process simply does not exist for closed-end funds or ETNs and this is what causes these funds to have discounts/premiums which can grow quite large and unchecked. Their share value is influenced by the level of demand for them.

In conclusion, we believe that all the true ETFs we recommend in our service, including the country ETFs should be liquid enough to trade safely without undue premiums. With this being said we need to reiterate our warning about the lack of true ETF for India. The only available funds for India are either closed-end funds such as IFN or Exchange Traded Notes such as INP, all of which present significant risks, short comings in tracking the India index and unpredictable price premiums/discounts. Read the December 14, 2007 FAQ of the Week for more details about this.

FAQ of the Week

Question: Do the TimingCube calls affect ETF prices?

To be honest, we are flattered when we hear this concern from existing or prospective subscribers, but our innate modesty compels us to admit that we are nowhere the size to cause substantive price changes in the ETFs impacted by our calls, be they Buy/Cash/Sell timing signals or World Index Ranking Top 5 rebalancing. A recent instance which raised many eyebrows had to do with our Friday December 14, 2008 "FAQ of the Week" "Why is INP on fire?" which stressed that the INP price premium had reached unsustainable levels, only for INP to lose over 13% of its value on the next trading day. As much as we would like to be responsible for this, it is simply not the case.

As detailed in the Trend Timing School article above, the liquidity of an ETF is that of the liquidity of the companies underlying the index it tracks. Unlike the price of closed-end ETFs and Exchange Traded Notes (ETNs) which can be affected by the demand/supply for the fund itself, ETF prices are primarily driven by the price of the index they track. With a few thousand followers we do not represent nearly enough volume to budge broad country indexes.

Warm wishes and until next week.

The TimingCube Staff

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