A Potential Problem With ETFs

It seems as if new specialized ETFs are being created every week. According to Morningstar, there are now more than 253 ETFs trading on various exchanges - an increase of 101 over a year ago at this time.

The problem I'm reporting on has to do with liquidity. However, this problem does not apply in the case of the older, more established ETFs like S&P Depository Receipts (AMEX: SPY), the DIAMONDS Trust (AMEX: DIA), or the NASDAQ 100 Trust (NASDAQ: QQQQ). These larger ETFs all trade with a daily share volume in the millions of shares.

But what about smaller ETFs like the 1st Trust Dow Jones Internet Index (AMEX: FDN), the Rydex Small-Cap 600 Pure Growth (AMEX: RZG), or Dow Jones Wilshire Large Cap (AMEX: ELR) - all of which have had days when there were zero trades.

Many other ETFs have serious liquidity problems too, with trades of fewer than 10,000 shares a day. And since liquidity also depends on popularity, it is quite possible that some of today's "hot" ETFs may be difficult to unload years from now. So if you invest in an ETF, the best course of action is to check the daily trading volume of any ETF in which you are invested, and don't invest unless the ETF has shown good liquidity in both bull and bear markets.

* * * * *