There is a liquidity problem for many Chinese ETFs

Size isn’t everything, but there are limits to how small traders are willing to get in pursuit of market-beating performance — especially in notoriously volatile emerging markets.

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The really big money often insists that an exchange-traded fund attract a minimum amount of assets before they’ll even look at the fund. This “AUM minimum” varies depending on the institutional investor, but you’d be hard pressed to find a floor below $10 million┬áhere.

Advisors to high-net-worth families are even more careful. One rule of thumb is to avoid any ETF that’s failed to accumulate less than $100 million.

In both cases, the rationale boils down to liquidity and operational risk. Even a massive fund like EEM (quote) or FXI (quote) will only trade 5% to 10% of its outstanding shares in an average day.

If the total float is only a few hundred thousand shares, then average volume would be maybe 10,000 to 30,000 shares. That’s the kind of liquidity we normally associate with sub-penny stocks, and it just isn’t going to inspire confidence that an investor will be able to build a substantial position without moving the price, much less close it out in a hurry.

And even within the ETF industry itself, it’s an open secret that it takes at least $50 million in investor assets to really turn a fund into a profitable enterprise. Until scale reaches that sweet spot, the portfolio runs the risk of failure and liquidation — wiping out all the work investors have put into learning the portfolio and how it fits into their overall strategy.

You’re probably not an institutional investor, so you’re not bound by their rules. Some traders like the feeling that they’re exploring areas of the market where bigger, slower pension funds and other institutions won’t play.

That’s fine. It’s good to feel adventurous and dangerous, and it’s a rush to realize you now own a big piece of a tiny $5 million portfolio.

But feeling the rush is an age-old way to lose money in the market when it turns on you. Your big piece of that $5 million portfolio might be trapped there for days. Do you sell at a discount or hang on, hoping for a recovery around the corner?

Investing is like flying. Always keep an exit in mind.

If you buy into a relatively illiquid ETF, know that you might not be able to exit until the fund succeeds to the point where the institutions — arguably the smartest guys in the market — are willing to invest alongside you.

That means betting on these funds may be a long-term proposition. That’s fine. But know what you’re getting into.

In China, for example, most of the funds with over $100 million in assets are the true giants like FXI with $6.6 billion on its books, followed by GXG (quote) way down at $600 million and other broad-line China funds.

The only true “niche” China portfolios in this category are the small-cap fund HAO (quote) and consumer fund CHIQ (quote) .

Below that, the universe thins out very quickly. The biggest of the Chinese sector funds, Guggenheim China Technology (CQQQ, quote), has amassed $25 million, and even at this level only moves around 9,000 shares on a good day. If it were a stock, it’d be a microcap company and a real long-term proposition.

The other China sector funds may tell attractive stories about the unique role they play in the Chinese economic miracle. Each does offer very fine-tuned exposure to Chinese companies you’re unlikely to discover on your own, much less trade.

But unless you’re eager to stay in the Chinese energy sector (CHIE, quote), Chinese factories (CHII, quote) or Chinese raw materials (CHIM, quote) for the long term — and even then risk liquidating your entire investment — it may be best to steer clear.

CHIM, for example, has attracted $2 million in shareholder funds over the last two years. About 0.6% of the float trades on a typical day. That’s maybe $16,000 in the game, session by session.

Maybe you’d be willing to invest $16,000 in a $2 million start-up. But in that case, you’d probably do a lot of due diligence, right?

Bottom Line: We quote these funds around here largely as a way to demonstrate sector performance, and not as a way to validate them as short-term trading ideas.

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