Rich Carreiro wrote:
- quote -

Rich,
I like ETFs generally but my gut is that these micro-cap ETFs are by
nature going to have noticeable tracking errors because of the low
liquidity of the stocks they hold.

With say SPY the arbitrage mechanism is relatively cheap and so you see
very small or nonexistent gaps between NAV and share price. But I'd be
surprised if it looks that way with these ETFs - it's difficult to trade
micro-cap stocks in any decent quantity. Anyone who trades individual
issues in that size has probably noticed this. A quantitative measure of
it is the liquidity ratio and for many of these stocks it's tiny, like
$100 or less. For a stock like that the (rough) model predicts that
trading $100 of the stock moves its price 1%. Needless to say the ETFs
are going to need to swallow bigger chunks than that as they create units.

And I'm aware that ETFs are used not just by the passive-investor types
but by active traders doing rapid tactical asset allocation. A glaring
example of is was the fact that some ETF dividends aren't qualified,
because the ETF hasn't met the holding period - as discussed recently.
This isn't like DFA's fund which is more buy & hold with limited actual
trading activity of the underlying issues. The unit creation/redemption
process it seems could lead to less stability - the market for these
issues isn't big - translating to higher costs from the friction of trading.

Another issue where the impact is unclear regards block trades of these
stocks. A certain fund company claims a trading advantage for these
stocks, their trade desk being sort of "known" as a place to get
liquidity in smaller issues. Now assumedly anyone on the other side of
that phone call - the representative of the exec at MicroCorp, looking
to unload a block of 50,000 shares - is going to call up Barclay's
trading desk now too, right? And with more than one trade desk active in
the market it seems logical that the pricing would be better...for that
exec. So in theory some of that trading advantage might erode. Though I
posed this question to someone once who brushed it aside as a non-issue.
I guess it's possible that the ETF and mutual fund use different buy
criteria, or manage this by avoiding buys when the market is bad for a
given issue, but it seems there is going to be overlap.

And at some level I wonder how many investors the micro-cap side of the
market can realistically absorb.

On the flip side, growth in these ETFs could potentially present some
"trading" opportunities - for someone who can game the individual issues
and figure out which will benefit from inflows to the ETF. If that's
possible, just leveraging knowledge about issues the ETF will be
"forced" to buy, it could result in "bad" pricing for the ETF holder,
and some quick profits by those holding the individual stocks.

-Tad

Any comments from the Boreks and belivasky's of the
world about the iShares and Zacks micro-cap ETFs?

--
Rich Carreiro rlcarr[at]animato.arlington.ma.us