Watch the Spread on Lightly Traded ETFs

04/20/2011 9:43 am EST

Focus: GLOBAL

John Heinzl

Reporter and Columnist, GlobeInvestor.com

Exchange traded funds have been dreamt up for all kinds of investment combinations, but that hardly means they’re all good deals, or even popular. John Heinzl, reporter and columnist for GlobeInvestor.com, explains the dangers of ETFs with poor liquidity.

I want to invest some of my “fun money” (about $15,000) in the Indian market. I found some exchange traded funds that I like (XID and ZID on the TSX), but the volume is really light and I don’t like that. What do you think? —G.P.

You’re referring to the iShares S&P CNX Nifty India Index Fund (Toronto: XID) and the BMO India Equity Hedged to CAD Index ETF (Toronto: ZID), respectively. You’re right about the light volume: Both ETFs often trade fewer than 10,000 units a day.

That isn’t necessarily a deal breaker. ETF companies use market makers, also known as designated brokers, to maintain an orderly, liquid market in their units. Because market makers buy and sell units when nobody else will, this keeps the ETF’s price from getting seriously out of whack with the value of the underlying securities.

The process isn’t perfect, however. With heavily traded ETFs, the spread between the bid (what you can sell the ETF for) and the ask (what you can buy it for) is seldom more than a penny.

But with thinly traded units, bid-ask spreads are typically much wider. As I’m writing this, the spread on XID is 6 cents, and on ZID it’s 8 cents.

That raises a red flag for some professional ETF investors.

“Liquidity is definitely a factor,” says Vikash Jain, vice-president of portfolio management with archerETF Portfolio Management in Oakville, Ontario. When bid-ask spreads are wide, you should use a limit order to specify your purchase price, he says. But it could take hours to complete the trade, and there’s no guarantee you’ll get filled at all.

That’s why he avoids ETFs with poor liquidity.

“Selling would be even more troublesome, especially if you need to sell in a hurry,” he adds. In that case, you’ll have to accept whatever the bid is, even if it’s well below the ask price.

(You can see the bid and ask prices when you enter an order with your broker. The bid and ask are also listed on Globe Investor under the “summary” tab when you call up a stock quote. The information is delayed by 15 minutes.)

As an alternative, he recommends looking into the US market for a more liquid ETF such as the WisdomTree India Earnings Fund (EPI). For broader emerging-market exposure, he likes the Vanguard MSCI Emerging Markets ETF (VWO), which invests in countries such as China, Brazil, South Korea, Taiwan, and India.

Both ETFs trade millions of units a day and have very tight bid-ask spreads.

I’ve taken money out of my line of credit to invest in stocks. The stocks I’m currently in, however, do not pay a dividend. Can I still deduct the interest I’ve been paying on my loan when I file my taxes? —K.W.

It depends.

According to the Canada Revenue Agency, interest on money borrowed for investment purposes is tax deductible “generally only as long as you use it to try to earn investment income, including interest and dividends.”

But there’s a lot of wiggle room here. Even if the company pays no dividends now, you can still deduct the interest if there is a “reasonable expectation” of receiving dividends down the road.

For example, if a company says it will reinvest its cash flow for the foreseeable future and will only pay a dividend when operational circumstances permit, or when it believes shareholders can make better use of the cash, the interest is tax deductible.

On the other hand, if a company has an explicit policy of not paying dividends now or in the future, interest would not be tax deductible. “Each situation must be dealt with on the basis of the particular facts involved,” the CRA says.

For more information, contact the Canada Revenue Agency or read CRA bulletin IT-533, titled “Interest Deductibility and Related Issues.”

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