When investing in mutual funds, the investor is handing his money over to a mutual fund manager, giving him or her full discretion in trading the asset as he or she sees fit. This is a simplified scenario, as behind the scenes there are usually a lot of internal and external controls put on the managers, but from the small investor’s standpoint, he has no say in how the fund is run.
Exchange Traded Funds (ETFs) bring much more transparency to the table. Instead of having no control and limited knowledge about what your investment assets are up to, ETFs allow you to know throughout the day what they hold and the value of those holdings. ETFs are also rule based, meaning that you will know exactly how an ETF will function, as its only objective is to track an index.
This gives the investor, who needs diversification, a way to have zero manager risk. This means that the investor now has control of a diversified basket of stocks in an inexpensive wrapper. With now hundreds of ETFs available, basically, any investment view can be expressed using ETFs.
With this power, comes more responsibility for the investor. ETFs are extremely efficient and effective tools and those who understand their basic principles can utilize them in almost every situation. On the flip side of that, a misunderstanding of the unique features and risks of ETFs can lead to problems.
This is why, as with any investment decision, it is best to at least get some advice or research report concerning the investment strategy and investment vehicle.
Supply and Demand
Sometimes when people ask me about ETFs and I can tell they don’t want a long answer, I say “ETFs are like mutual funds that trade like stocks and track an index at a low cost.” This statement is true and not true at the same time. It’s like a mutual fund in that it is a way to be diversified and like a stock in the way you can trade it throughout the day.
It’s this “throughout the day” that is important to distinguish here. Stock prices are set by the demand for that particular stock. An increase in buying demand will cause the price to increase just like selling demand will drive prices down.
ETFs Are Followers Not Leaders
ETFs, unlike stocks are price followers, as their price is not determined by supply and demand. To be clear, just like a stock, the price will change with demand but this is artificial since ETFs are simply tracking its holdings’ market prices. With traditional ETF structures, the ETF’s objective is to track an index. The ETF company will put together a basket of stocks, bonds, or futures and options (when tracking asset classes like commodities). The price of this basket is called the ETF’s NAV or net asset value. The ability of this NAV to track the index is measured by its tracking error.
The ETF will then trade on the market at a price which should, in theory, reflect the NAV. When the market price is above the NAV price, the ETF is trading at a premium. When the price is below NAV, the ETF is trading at a discount.
This is why, when buying and selling positions of ETFs, it is best to use a limit order. A limit order will buy or sell an ETF at a determined price or better. A limit order guarantees a price but not execution. In this way, you are trying to buy the ETF that reflects its characteristic as a price follower not a price determined by demand.
Using a limit order to buy and sell ETFs is a smart way to reflect an understanding that ETFs sometimes trade at a premium or a discount to NAV and that when you buy a large amount of ETFs that have low trading volume, you may not get the price you wanted or thought. A smarter way to buy would be to set a limit order at NAV, since ETFs are followers of that NAV price. The NAV price for an ETF can be obtained from your broker’s trading desk. At a recent Power Shares event, it was mentioned that a good rule of thumb is to place a limit order between the bid and ask price for an ETF. This spread can be pennies and in some cases dollars.
If an investor placed a market order to buy an ETF, a scenario could be the following:
NAV for XYZ ETF is 90. The Bid is 89.9 and the Ask is 90.1. There are Sell Limit orders from the market as follows:
Limit 92 1000 shares
Limit 91.5 1000 shares
Ask 90.1 1000 shares
Your market order for 1000 shares is placed the same time as another investor’s 1000 share market order. Your order’s que is milliseconds behind the other which allows the first purchase to get the NAV price at 90, then your order got routed to the next available price at 91.50. You just paid a $1.5 premium per share!!! If you had used a Limit order at NAV, your order would have waited in que for the next seller at NAV.
Why ETF Trading Volume Does Not Matter
For an ETF purchaser or seller, ETF trading volume does not matter. ETF trading volume is the number of shares of the ETF that have traded over a time period. This is usually reported daily.
If a new ETF came out tracking the S&P 500, it may have low trading volume, especially if it charged more than the ETF’s tracking that index already on the market. Even if the volume of the ETF was very low, that does not mean that the ETF is illiquid or will fail to execute its objective. If properly handled, the investor would place a limit order at the ETF’s NAV. Should there not be enough demand to execute the order, the market maker will go onto the market and purchase the stock within the index then convert the shares into shares of the ETF, which will allow for the order to be executed. The reverse would happen in a sell situation. In reality, if you place a NAV limit order and it is not executed quickly and you are in a low volume situation, call your trading desk. The trading desk will contact the market maker.
Large orders will not “move the market” but will actually get poor pricing if limit orders are not placed.
The issue of liquidity and ETFs brings me to my last point, which is exceptions. What we have covered above are some principles of ETF investing that investors should be aware of in general. The point of view I took was from an investor, not a trader (who may be very concerned with bid/ask spreads). With limit orders and knowing the NAV, we aren’t too worried about that spread. There are always exceptions to these ETF principles.
For instance, ETFs that track indexes trading overseas have a unique attribute. Where most ETFs are price followers, these ETFs can have an element of price discovery. This happens when new information comes into the market when overseas markets are closed and investors have only the ETF through which to express the information. There are other instances of this in the bond markets where market-to-market pricing is used and ETFs can add liquidity to a bond market that is not liquid.
All and all, ETFs make the market more efficient. They are a powerful tool for any investor at any size. It is because they are powerful tools that they need to be understood. I recommended that advice be sought before investing on your own.
– Casey Smith is the President of Wiser Wealth Management