Exchange-traded funds are one of the most important and valuable products created for individual investors in recent years. ETFs offer many advantages and, if used wisely, are an excellent vehicle for achieving an investor’s investment goals.
Simply put, an ETF is a basket of securities that can be bought or sold through a brokerage firm on a stock exchange. ETFs are offered in virtually every conceivable asset class, from traditional investments to so-called alternative assets, such as commodities or currencies. In addition, innovative ETF structures allow investors to short markets, gain leverage and avoid taxes on short-term capital gains.
After a couple of false starts, ETFs got their start in earnest in 1993 with the product commonly known by its symbol, SPY, or “Spiders,” which became the highest volume ETF in history. In 2021, ETFs are estimated to reach $5.83 trillion with nearly 2,354 ETF products traded on US exchanges.
Types of ETFs
- Market ETFs: Designed to track a specific index such as the S&P 500 or the NASDAQ
- Bond ETFs: Designed to offer exposure to virtually every type of bond available: US Treasury, corporate, municipal, international, high yield, and many more
- Sector and industrial ETFs: Designed to offer exposure to a specific sector, such as oil, pharmaceuticals or high technology
- Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn
- Style ETFs: Designed to follow an investment style or market-cap approaches, such as large-cap value or small-cap growth
- Foreign Market ETFs: Designed to track non-US markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng.
- Inverse ETFs: Designed to benefit from a decline in the underlying market or index
- Actively Managed ETFs: Designed to outperform any index, unlike most ETFs, which are designed to track an index
Exchange-Traded Notes (ETNs): Essentially, they are debt securities backed by the creditworthiness of the issuing bank, which were created to provide access to illiquid markets; have the added benefit of generating virtually no capital gains tax in the short term
- Alternative Investment ETFs– Innovative structures, such as ETFs, that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call issuance
How do ETFs work?
An ETF is bought and sold like a company’s stock during the day when the exchanges are open. Like a stock, an ETF has a ticker symbol, and intraday price data can be easily obtained during the course of the day.
Unlike a company’s shares, the number of outstanding shares in an ETF can change daily due to the continual creation of new shares and the redemption of existing ones. An ETF’s ability to issue and redeem shares on an ongoing basis keeps the ETF’s market price in line with its underlying securities.
Although designed for individual investors, institutional investors play a critical role in maintaining the ETF’s liquidity and tracking integrity by buying and selling creation units, which are large blocks of ETF shares that can be traded for baskets. of the underlying securities. When the price of the ETF deviates from the value of the underlying asset, institutions use the arbitrage mechanism offered by the creation units to bring the price of the ETF back in line with the value of the underlying asset.
Advantages of ETFs
For nearly a century, traditional mutual funds have offered many advantages over building a portfolio of stocks one at a time. Mutual funds offer investors wide diversification, professional management, relatively low cost, and daily liquidity.
Exchange-Traded Funds (ETFs) take the benefits of mutual fund investing to the next level. ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and greater tax efficiency in taxable accounts. However, there are drawbacks, such as trading costs and the complexity of learning the product. Most financial experts agree that the benefits of ETFs outweigh the drawbacks by a considerable margin.
The appeal of ETFs:
- Ease of trading– You can buy and sell at any time of the day, unlike most mutual funds that trade at the end of the day
- Transparency– Many ETFs are index-based; index-based ETFs are required to publish their holdings daily
- Greater tax efficiency– ETFs typically generate a lower level of capital gains distributions than actively managed mutual funds.
- Trading operations– Because they are traded like stocks, investors can place various types of orders (for example, limit or stop-loss orders) that cannot be made with mutual funds
ETFs have several advantages over traditional open-end funds. The four main advantages are trading flexibility, portfolio diversification and risk management, lower costs, and tax advantages.
Traditional open-end mutual fund shares are only traded once a day after the markets close. All trading is done with the investment fund company that issues the shares. Investors should wait until the end of the day, when the fund’s NAV is announced, to find out the price they have paid for new shares when buying that day and the price they will receive for shares they have purchased. sold that day. Trading once a day is fine for most long-term investors, but some people need more flexibility.
ETFs are bought and sold during the day when the markets are open. The ETF share price is continuous during normal trading hours. Share prices vary throughout the day, based primarily on the intraday change in value of the fund’s underlying assets. ETF investors know in a moment how much they have paid to buy shares and how much they have received after selling them.
The near-instantaneous trading of ETF shares makes intraday portfolio management a doddle. It’s easy to move money between specific asset classes, such as stocks, bonds, or commodities. Investors can effectively place their allocation in the investments they want in one hour and then change their allocation in the next hour. In general, this is not recommended, but it can be done.
Making changes to traditional open-ended mutual funds is more difficult and can take several days. First, there is usually a cut-off time, 2:00 p.m. ET, for open-ended trading. This means that there is no telling what the NAV price will be at the end of the day. It’s impossible to know exactly how much you’ll receive when you sell shares of one open-ended fund or know how much to buy from another open-ended fund.
The flexibility of ETF trading orders also gives investors the advantage of making timely investment decisions and placing orders in a variety of ways. ETF stock investing has all the trading combinations of common stock investing, including limit orders and limit orders. ETFs can also be purchased on margin by borrowing money from a broker. Each brokerage firm has tutorials on the types of trading orders and the requirements for borrowing on margin.
Short selling is also available to ETF investors. Short selling involves borrowing securities from your brokerage company and simultaneously selling those securities on the market. The hope is that the price of the borrowed securities will go down and you will be able to buy them back at a lower price at a later time.
Portfolio diversification and risk management
Investors may want to quickly gain portfolio exposure to specific sectors, styles, industries, or countries, but have no experience in those areas. Given the wide variety of sector categories, styles, industries, and countries available, ETF shares can provide an investor with easy exposure to a specific desired market segment.
Today, ETFs are traded in virtually every major asset class, commodity, and currency in the world. In addition, new and innovative ETF structures embody a certain investment or trading strategy. For example, through ETFs, an investor can buy or sell the volatility of the stock market or continuously invest in the world’s highest-yielding currencies.
In certain situations, an investor may have a significant risk in a particular sector but cannot diversify that risk due to restrictions or taxes. In that case, the person can short a sector ETF or buy an ETF that shorts a sector for them.
For example, an investor may hold a large number of restricted shares in the semiconductor industry. In that situation, the person may want to short Standard & Poor’s (S&P) SPDR Semiconductor (XSD) stock. That would reduce global exposure to downside risk in that sector. The XSD is an equal-weighted market capitalization index of semiconductor securities traded on the New York Stock Exchange, the American Stock Exchange, the NASDAQ National Market, and the NASDAQ Small Cap.
All managed funds incur operating expenses, regardless of their structure. These costs include, but are not limited to, portfolio management fees, custody costs, administrative fees, and marketing and distribution fees. Costs have historically been very important in predicting profitability. In general, the lower the cost of investing in a fund, the higher the expected return for that fund.
The operating costs of ETFs can be lower than those of open mutual funds. The reduction in costs is due to the fact that the expenses related to customer service are transferred to the brokerage companies that maintain the listed securities in the clients’ accounts. Fund administration costs can be reduced for ETFs when a company does not have to staff a call center to answer questions from thousands of individual investors.
ETFs also have lower expenses in the area of monthly statements, notifications, and transfers. Traditional open-end fund companies are required to send regular statements and reports to shareholders. This is not the case with ETFs. Fund sponsors are responsible for providing this information only to authorized participants who are the direct owners of the units of creation. Individual investors buy and sell individual shares of similar securities through brokerage firms, and the brokerage firm becomes responsible for serving those investors, not the ETF firms.
Brokerage firms issue monthly statements, annual tax reports, quarterly reports, and 1099s. Reducing the administrative burden of servicing and keeping records for thousands of individual clients means ETF firms have less overhead, and at least part of Those savings are passed on to individual investors in the form of lower fund expenses.
ETFs have two big tax advantages compared to mutual funds. Due to structural differences, mutual funds typically incur more capital gains taxes than ETFs. Additionally, capital gains tax on an ETF only occurs at the time of the investor’s sale of the ETF, while mutual funds pass capital gains taxes on to investors throughout the life of the investment. In short, ETFs have lower capital gains and are only paid when you sell the ETF.
The tax position of dividends is less advantageous for ETFs. There are two types of dividends issued by ETFs, qualified and non-qualified. For a dividend to be classified as qualified, the investor must hold the ETF for at least 60 days prior to the dividend payment date. The tax rate on qualified dividends varies between 5% and 15% depending on the investor’s tax rate. Nonqualified dividends are taxed at the investor’s tax rate.
Listed notes, which are considered a subset of exchange-traded funds, are structured to avoid the taxation of dividends. ETNs do not issue dividends; however, the value of the dividends is reflected in the price of the ETN.
ETF Portfolio Composition Data
Fidelity provides different levels of data for each ETF that can be traded on Fidelity.com. This data is based on the holdings of each ETF at the end of the previous trading day.
Daily Basket: Through the daily basket, also known as a portfolio composition file (PCF), Fidelity provides a daily list of securities held by each of the more than 2,000 non-Fidelity-sponsored ETFs that investors can trade through the Fidelity website, as well as all Fidelity-sponsored ETFs.
This daily file is provided by the National Securities Clearing Corporation (NSCC). The NSCC reports clear and settles ETFs and their underlying securities through its creation/redemption process. This process allows authorized participants (large institutional investors) to create personalized portfolios excluding specific securities rather than cash. ETFs can also be created and redeemed against cash (rather than securities) to support ETF processing at NSCC.
Complete Portfolios: In addition to the daily PCF, Fidelity provides a link to the daily complete holdings file for Fidelity-sponsored ETFs. Click on the ETF prospectus and select “Holdings & Reports” to view the most recent daily file of full holdings. The main difference between the PCF and the full share daily file is that the full share daily file includes the cash items, while the PCF only includes the values cleared through the NSCC. If you are interested in the complete holdings of an ETF sponsored by a company other than Fidelity, that information can be found on the ETF sponsor’s own website.
Index Constituents: If an ETF sponsor does not submit or clear its data through the NSCC, then the PCF is flagged by the data provider to indicate that it only represents securities held by the index that the ETF tracks.
While there are differences between what you might see as an ETF’s holdings at any given time—the daily basket, the full daily holdings, and the index constituents—these differences are typically minor. Although there is no guarantee, the differences are usually a small fraction of a percentage of cash holdings or an individual component.
Disadvantages of ETFs
However, ETFs have drawbacks, including
- Dealing costs –If you invest small amounts on a regular basis, there may be lower-cost alternatives to investing directly with a fund company in a no-load fund
- Lack of liquidity –Some thinly traded ETFs have wide bid and ask spreads, meaning you will buy at the higher price on the spread and sell at the lower price on the spread.
- Tracking Error –Although ETFs typically track their underlying index fairly well, technical issues can create discrepancies.
- Settlement dates –ETF sales are not settled until 2 days after the transaction; this means that, as a seller, your funds from an ETF sale are technically not available to reinvest for 2 days.
Once you have determined your investment objectives, ETFs can be used to gain exposure to virtually any market in the world or any industry sector. You can invest your assets conventionally using bond and stock index ETFs, and adjust your allocation based on changes in your risk tolerance and goals. You can add alternative assets, such as gold, commodities, or emerging stock markets. You can jump in and out of markets quickly, hoping to catch short-term swings, similar to a hedge fund. The thing is, ETFs give you the flexibility to be the investor you want to be.
What the future holds?
Innovation has been the hallmark of the ETF industry since its inception more than 27 years ago. No doubt new and more unusual ETFs will be introduced in the coming years. Although innovation is a positive aspect for investors, it is important to know that not all ETFs are created equal. Before investing in an ETF, you should carefully research and consider all factors to ensure that the ETF you choose is the best vehicle to achieve your investment objectives.
What’s in your ETF?
Understand ETF Portfolio Composition: Learn how to find a daily breakdown of what’s in your ETF.
One of the attractions of Exchange Traded Funds (ETFs) is that they can be highly transparent investment vehicles. This makes it easy for investors to target a particular asset class, geographic region or sector, without worrying whether the fund manager may be investing in securities outside the fund’s mandate, a phenomenon known as ‘style drift’.
The ETF holdings offered on Fidelity.com give you an overview of the composition of each portfolio, which can help you make informed investment decisions and compare the objective of each ETF with the characteristics of its underlying holdings.
Differences in ETF basket and holdings
The holdings in an ETF portfolio originated through what are known as “redemption and creation baskets.” Unlike mutual funds, ETFs do not necessarily have to sell individual securities to satisfy shareholder redemption requests. Through a process known as “create and redeem,” ETFs can use an authorized participant to act as a clearinghouse to facilitate shareholder redemption requests.
ETF shares are created when an authorized participant deposits a portfolio of shares into the fund in exchange for an institutional block of ETF shares (between 25,000 and 600,000). This is called “in-kind” creation because a basket of shares is exchanged for shares of the ETF instead of using cash. However, under certain circumstances, some ETFs allows the creation (and redemption) of ETF shares in cash, rather than through the “in-kind” process.
The portfolio composition page for each ETF provides more details on the holdings and objectives of each ETF available through Fidelity.com. This includes an overview of the characteristics of the ETF’s current holdings compared to their targets. For example, does the ETF have securities with exposure to foreign countries or regions? What percentage is held in small-cap stocks, in a particular sector or industry, or in types of corporate or municipal debt?
How to Evaluate an ETF?
Not all ETFs are equally efficient, so it’s important to track a fund’s expense ratio, tracking results, and capital gains history when evaluating an ETF.
The homebuilder who builds sturdy houses that stand for hundreds of years does a better job than one whose houses collapse after a short time.
That’s a neat way to assess how well a homebuilder does their job, but what about ETFs? How do we judge how well an ETF does its job?
In short, judging its efficiency. An efficient ETF produces the maximum results with the minimum expenses.
In the case of ETFs, the main input factor is the fund’s expense ratio, that is, the rate the fund charges for doing its job. Since the function of most ETFs is to track an index, we can assess the efficiency of an ETF by weighing the commission rate the fund charges and how well it “tracks” – or replicates – the performance of its index. ETFs that charge low fees and closely track their indices are very efficient and do their job well.
An obvious starting point is commissioned: the lower the better. But while that’s a good starting point, not all low-fee funds will track their indices well. Therefore, it makes sense to focus on the results of monitoring a fund. How well did the ETF replicate the performance of its index? When the index rose, did the ETF rise by the same amount?
A favorite measure is a trailing difference, a statistic that looks at how far an ETF has lagged behind its benchmark, on average, over a one-year period. The tracking difference incorporates the effects of a whole range of management decisions, from securities lending to optimization decisions. Since the main task of most ETFs is to track an index, funds that deviate from their index – even for short periods – are less efficient and poorly managed.
Distribution of capital gains
However, it’s not just about performance. Investors also turn to ETFs for tax reasons. By their very structure, ETFs are built to be tax-efficient and, as such, must also be evaluated for their tax efficiency.
We consider the distribution rate of capital gains. This can be measured by taking the average capital gains paid to shareholders during a recent period divided by the NAV at that time. Lower values are better here, as they maximize tax efficiency.
You can also consider the general tax treatment of the fund itself: Equity ETFs are inherently more tax-efficient for long-term holders than currency funds, for example.
Aside from tracking and taxes, the last factor investors need to consider is a risk. Is the ETF likely to close? If it is a listed ticket (ETN), does it have counterparty risks that make it unfeasible? In general, ETFs are well-structured investments, but it’s always helpful to take a look behind the curtain.
How to choose the right ETF?
Know what you own. Don’t assume that all ETFs are the same because they definitely are not.
ETFs are great. But how to choose?
With so many ETFs on the market today, and with more launches each year, it can be difficult to determine which product will work best for your portfolio. How should you assess the ever-expanding ETF landscape?
Start with the benchmark
Many people like to focus on the ETF’s expense ratio, its assets under management, or its issuer. All of that is important. But for us, the most important thing about an ETF is its underlying index.
We are conditioned to believe that all indices are equal. A good example of this is the S&P 500 and the Russell 1000. What’s the difference?
The answer is that there isn’t much. Sure, the Russell 1000 has twice as many values as the S&P 500. But in a given period, the two indices have the same number of values. But in a certain period, the two behave in a similar way.
But in most other cases, the rates matter…a lot. The Dow Jones Industrial Average has 30 stocks, and neither looks nor performs like the S&P 500. A popular China ETF tracks an index that is 50% financials; another tracks an index with no financial values at all.
One of the nice things about ETFs is that they (for the most part) post their holdings daily. So take the time to look under the hood and see if the holdings, sector, and country breakdown make sense. Do they match the asset allocation you have in mind?
Pay special attention not only to the stocks or bonds an ETF owns but to their weighting. Some indices weight their holdings more or less equally, while others allow one or two big names to carry the load. Some seek broad market exposure, while others take risks in an attempt to outperform the market. All of this information can be found in the offering prospectus, in the fact sheet of any ETF, or in the “Portfolio Composition” tab of Fidelity’s fund pages.
Know what you own. Don’t assume that all ETFs are the same because they definitely are not.
What is your tracking difference?
Once you’ve found the right index, it’s important to make sure the fund is reasonably priced, well-managed and tradable.
Most investors start with a fund’s expense ratio: the lower the better.
But expense ratios are not the most important thing. As the old saying goes, it’s not about what you pay, it’s about what you get. And for that, you need to look at the “tracking difference” of a fund.
ETFs are designed to follow indices. If an index goes up 10.25%, a fund should also go up 10.25%. But it is seldom so.
First, expenses are a drag on profitability. If 0.25% annual fees are charged, the expected return will be 10.00% even (10.25%-0.25% annual fees). But spending aside, some issuers track the indices better than others. Also, some indices are easier to follow than others.
Let’s start with the base case. In the case of a large-cap US equity index, such as the S&P 500, most ETFs that track that fund use what is called “full replication.” This means that they buy all the securities of the S&P 500 in the exact proportion that they are represented in the index. Before transaction costs, this fund should track the index perfectly.
But what if you follow an index in Vietnam that has a lot of turnovers? Transaction costs can detract from returns.
Sometimes fund managers buy just some — not all — of the stocks or bonds in an index. This is called “sampling” or, more optimistically, “optimization.” A sampling strategy typically tries to replicate an index but may perform slightly better or less depending on the values it has.
There are other factors that can influence monitoring, such as the quality of the ETF manager in monitoring cash positions and executing trades, or the management of its stock lending portfolio. In general, the lower the tracking difference – especially downward – the better.
If a fund has the right strategy and is well managed, you will decide if you can buy it. After all, trading costs can detract from your profitability if you’re not careful.
The three things to look for are:
- The liquidity of the fund
- Your buy/sell margin
- Your tendency to trade in line with your true net asset value
The liquidity of an ETF comes from two sources: the liquidity of the fund itself and the liquidity of its underlying shares. Funds with higher average daily trading volume and more assets under management tend to trade with tighter spreads than funds with less daily trading or fewer assets.
There is no perfect rule about what constitutes sufficient volume, but in general, an ETF with an average daily trading volume of more than $10 million can be considered liquid. Bid/Ask spreads below 0.10% can be considered tight. The caveat is that preferences will vary depending on cost sensitivity and holding period: Very cost-conscious investors and traders with a very short time horizon might prefer funds with higher volumes and tighter spreads.
However, even funds with limited trading volume can trade at low spreads if the fund’s underlying securities are liquid. An ETF that invests in S&P 500 stocks, for example, will likely be more liquid and trade on tighter spreads than one that invests in small Brazilian companies or alternative energy companies. Please refer to the key stats tab of any ETF for a full breakdown of liquidity stats.
For individual investors, leveraged ETFs can be attractive due to their higher return potential.
Leveraged ETFs have received tremendous media attention and are proving extremely popular with individual and institutional investors. There are hundreds of leveraged ETFs, covering virtually every asset class and industry sector. Most are double-leveraged, but there is a sizable group of triple-leveraged ETFs.
For professional investors, leveraged ETFs are useful in statistical arbitrage, short-term tactical strategies, and for use as short-term hedging without the need to roll futures. Leveraged ETFs are attractive to individual investors because of their potential for higher returns.
What does leverage mean in ETFs?
Uninformed investors might assume that returns on leverage are generated continuously so that if an underlying index is up 5% for a month, the double-leveraged ETF will be up 10% for the same month; if the index goes up 10% over 6 months, the ETF will go up 20%, and so on. This is not so at all. Leverage is determined daily and returns in any other period are typically not double or triple the underlying index.
In order for leveraged funds to reach the proper asset levels to be able to provide their implied leverage, they have to rebalance on a daily basis. In the case of an ETF providing 2x leveraged long exposure, they would typically achieve exposure to a notional pool of assets equal to 2x their NAV. An example would be an ETF that takes 100 units of assets that swaps with a counterparty to provide exposure to 200 units of yielding assets. The rebalancing activity of these funds will almost always be in the same direction as the market.
Essentially, a leveraged ETF is marked for the market every night. It starts with a clean slate the next day, almost as if the day before never existed. This process produces daily leverage results. However, over time, the composition of this rebalancing can potentially change the performance of the fund against its underlying benchmark. This may result in a greater or lesser degree of ultimate leverage over individual holding periods.
While using reverse ETFs can provide you with some advantages, it can also lead to significant losses.
Commodity funds have provided individual investors with access to hard and soft commodities. Many of these products were not previously available for portfolio allocation on such a wide scale and are driving changes in how they are applied to portfolio building large and small.
Like leveraged products, inverse ETFs use leverage to deliver their intended returns. Leverage is a way of measuring financial leverage, specifically, it is the relationship between leverage and equity. In the case of a normal inverse ETF, the leverage ratio will be 1. In the case of a short leveraged fund, the leverage can be 2 or even 3 times. There are far more short leveraged products than there are products that offer reverse exposure. Inverse funds exhibit the same traits as leveraged funds in terms of composition and rebalancing, but these effects are tempered by the low leverage of the products. Effects are also volatility dependent and will wax and wane proportionally.
Essentially, like leveraged products, these funds hold swaps to gain exposure. A short S&P 500 fund would hold a swap, paying index returns to the counterparty. If the index traded higher on a given day, the ETF would have to pay the index returns to the counterparty, causing the value of the ETF to decline. If the index trades lower, the ETF will receive the return of the index, causing its net asset value (NAV) to increase on that day.
To achieve the daily return of the index on an ongoing basis, the funds will reset their holdings daily in the same way as leveraged products. Inverse funds bring an important tool to the investment community in the form of long negative exposure.
Trading and Liquidity
You can trade and access liquidity with inverse ETFs in the same way as with any other ETF. If you are a buyer of the inverse S&P fund, for example, you can buy it from the market electronically or you can go to a liquidity provider for NAV-based execution or provide you with a large black market. In this case, the liquidity provider (LP) would be selling the inverse S&P fund to you, thus having long exposure to the S&P 500. To hedge, the LP would have to sell some form of correlated exposure, be it the basket, futures, or another derivative to offset the long exposure. This is the opposite scenario of the LP selling an ETF based on long exposure to a client.
There are some important factors to understand about inverse ETFs when trading them. They’re a way to get downside market protection on accounts that normally can’t get that kind of access, like IRAs. You can buy a product that will increase in value when the market goes down. This opens up a whole new way to position your portfolio. Previously, long-term investors had the opportunity to have long exposure to the market or cash; they can now take advantage of, or hedge against, anticipated downward moves in the market. This could have a profound effect on how investment portfolios are managed in the future.
Another characteristic of inverse products is the changes in their exposure. For those who were able to short previously listed products, these products offer a way to short the market without the risk of unlimited losses. When you short a stock or ETF in the market, you expose yourself to that position potentially going up infinitely. Your portfolio could suffer devastating losses. When using an inverse ETF, losses are limited to the amount that has been invested in the position.
However, when the position is hit – when an inverse ETF is used and the underlying exposure goes down – the exposure to that position also increases. When the market moves down, your ETF’s NAV should rise, increasing your notional exposure to the position, if the accumulated address is correct. This is the opposite effect of a typical short position where your notional exposure decreases as the market moves down.
Although inverse ETFs are a very important and functional tool, how you use them is critical to your investment performance. It is very important to distinguish between investment objectives and time horizons and to understand what potential market activity can do to your portfolio’s performance.\
Interest in commodity-based ETFs has skyrocketed and shows no signs of slowing down. In the commodities space, there are 4 basic ways to gain exposure:
- Physically Backed Funds
- Equity Funds
- Futures-based funds
- Exchange Traded Notes (ETNs)
Each of these varieties has advantages and disadvantages. When considering which fund is best suited for your portfolio, you need to be particularly picky about the fund’s goal and how it pursues that goal. Does the ETF own the physical commodity or does it use futures contracts to replicate the exposure? Do you own shares of companies dedicated to the production of a certain raw material? Your investment decision should be based on more than just the name of the ETF. Just because a fund’s name includes “oil,” “natural gas,” “gold,” etc., you can’t be sure how that fund achieves exposure to that particular commodity. To choose the best option that suits your portfolio, you need to explore the options and see where and how you can look for the land of profit.
Physical Commodity ETFs
As the name suggests, physical commodity ETFs actually own the underlying commodity. A visit to the SPDR Gold Shares website for SPDR Gold Trust (GLD) gives you the details of this ETF: Investors get a share of the fund’s gold bullion reserves without having to take physical delivery or worry about the logistics, such as storage and securing of physical gold. Other bullion-backed ETFs are iShares Comex Gold Trust ( IAU ) and ETFS Physical Swiss Gold Shares ( SGOL ).
One caveat for investors who want to access physical gold is the tax implication. Unlike other ETFs, gold-backed funds are taxed up to 25% as collectible property. Therefore, these funds are more suitable for long-term investors looking to diversify a larger portfolio.
Commodity Exposure Based on Equities
Another way to gain exposure to commodities is through the companies that produce, transport, and store them. An equity-based commodity ETF offers “leverage-like” exposure to commodities through the shares of companies that are dedicated to natural resources and other commodities. These equity funds are viable alternatives to futures-based ETFs, which may be subject to trading limits and other regulatory restrictions. Additionally, equity-based commodity ETFs have better tax implications than ETFs that hold physical holdings of precious metals.
For example, investors looking for gold exposure can find equity-based alternatives such as Market Vectors Gold Miners (GDX) and Market Vectors Junior Gold Miners (GDXJ). GDX offers exposure to companies from around the world that are primarily engaged in gold mining, including large, mid and small caps. The GDXJ tracks small and mid-cap companies engaged in gold and/or silver mining. Both funds are treated like shares for tax purposes, making these funds more suitable for short-term participants in the gold market.
Futures-Backed Commodity Funds
Futures-backed commodity funds are designed to create exposure to the target commodity through the use of futures contracts, forwards and swaps. This type of ETFs is surrounded by great uncertainty when it comes to investing. This is because their need to buy and sell large numbers of futures contracts sometimes puts them in the position of influencing futures prices, rather than simply following prices. Faced with the possibility of commodity bubbles, the Commodity Futures Trading Commission recently proposed limits on positions in futures contracts, forcing some of these funds to create new mechanisms to track their futures contracts. underlying raw materials.
Use ETNs to access raw materials
The fourth way to access commodities is to use ETNs, which are senior, unsubordinated, unsecured debt issued by an institution. ETNs are linked to a number of assets, such as commodities and currencies. ETNs are designed so that there is no “tracking error” between the product and its underlying index. Owners of an ETN such as the iPath Dow Jones-UBS Commodity ETN (DJP) will earn the return of the index, less management fees.
Commodity ETNs also offer more favorable tax treatment than commodity ETFs. Investors who hold a commodity ETN for more than a year only pay a 15% capital gains tax when they sell the product. Futures-based commodity ETFs are taxed like futures, and earnings are valued at market price each year. This tax difference of 23% versus 15% has helped attract investors to ETNs.
With so many advantages, especially the tax treatment of commodity ETNs, why isn’t this category booming? One of the concerns about ETNs is the credit risk of the issuing bank. After the financial crisis, it is not so difficult to imagine bank failures that, not so long ago, would have seemed like a rare, once-in-a-century event. In addition to credit risk, ETNs that track futures also have regulatory risk.
As we have seen with futures-backed ETFs, regulatory restrictions on a fund’s participation in the futures market can affect an ETN as well.
Commodity Exposure: A Cautionary Tale
In general, the further away the target market is, the greater the chance that the investment instrument will not exactly track the underlying commodity. Physically backed gold, silver, platinum and palladium funds reflect the forces of supply and demand in the physical material market and as such closely track market prices. Of course, this exposure is not possible with all raw materials.
Equity-based commodity funds can give you exposure to the commodity – whether it’s gold, natural gas, oil or another substance – through the companies that produce, process and transport it. Although not the same as a physically backed fund, the equity alternative restores transparency and removes the possibility of regulatory limits that could affect trading.
Futures-backed funds and ETNs may offer certain advantages over physically-backed funds and equity funds; however, those benefits come at a cost: namely tracking discrepancies with the underlying commodity, regulatory risk, and potentially even credit risk. Investors should be aware of these issues in order to make the best selection according to their objectives and risk tolerance.
International investing can be an effective way to diversify your equity holdings. Although returns have lagged behind US markets, international ETFs offer diversification benefits as they tend to be less correlated to US equities.
Broad Exposure or Specific Operations?
The degree of international exposure that is right for you depends on your risk tolerance and level of involvement. If you want to take a more relaxed approach, you’re better off opting for a broad-based international equity fund that offers exposure to multiple countries. For a more active approach, you can opt for a single-market ETF, as long as you’re willing to track your investment on a daily basis.
In general, most investors prefer to include a mix of developed and emerging markets in their international equity holdings. This can be achieved through ETFs specifically targeting these sectors.
The Vanguard European ETF (VGK) tracks an index of companies located in Europe’s major markets, with around 20% of the fund’s holdings made up of UK companies, with lesser amounts dedicated to companies from Switzerland, Germany and France. . SPDR DJ Euro Stoxx 50 ETF (FEZ), by contrast, has a similar structure but maintains a slightly different mix, with 34% of its holdings in France and 29% in Germany. The thing is, there are several ETFs targeting non-US developed economies that investors can consider.
A broad-based approach similar to emerging markets can be taken with ETFs that focus on multiple countries in one or multiple regions. For example, iShares MSCI Emerging Markets ETF (EEM) focuses on several emerging markets, including (as of July 23, 2020) China (accounting for 38.96% of fund holdings), Taiwan (12.15%) , South Korea (10.88%), India (7.36%) and Brazil (4.9%), followed by South Africa, Russia and Saudi Arabia, among others. A similar fund is the Vanguard Emerging Markets ETF (VVO) with maximum holdings (as of July 23, 2020) from China (42.01%), Taiwan (15.44%), India (8.6%), Brazil (5.76%) and South Africa (3.93%), followed by Russia, Saudi Arabia, Thailand, Malaysia and others.
For a somewhat more focused strategy, investors can take the well-known BRIC approach that focuses on the combination of Brazil, Russia, India and China, which has long been the gold standard of investing in emerging brands. This brings to mind BRIC funds such as the iShares MSCI BRIC ( BKF), Claymore/BNY Mellon BRIC ( EEBo), and SPDR S&P BRIC 40 ( BIK). Although these funds target the same countries, each takes a slightly different approach.
Promises and Difficulties of a Single Country
Although BRIC ETFs remain popular, risk-tolerant investors have taken a more active and hands-on approach, pursuing new emerging market ETF opportunities with funds that focus on individual countries such as Russia, Vietnam, Thailand, Turkey and South Korea. However, before jumping into a single-country strategy, there are some serious potential drawbacks to be aware of, as well as the promise of strong returns.
When adding single country exposure to your portfolio, be aware of the possibility of overlap if you also have a regional ETF. Overlap occurs when a broader-based fund includes exposure to a particular sector or market, which is then increased by a more specific ETF: for example, let’s say you owned the Vanguard Europe ETF (VGK). You would want to know that almost 15% of the fund’s holdings (as of July 23, 2020) are in Germany before adding a narrow ETF like the iShares MSCI Germany Index Fund (EWG).
Overlap isn’t the only concern when it comes to investing in a single country: You may be exposed to currency risk. And not only that, the more specific the focus, the more carefully one has to watch for sudden events that could turn a potential growth story into a worrying scenario. For example, in February 2010, Greece’s economic woes grabbed headlines amid fears that the country might default on its debt payments. Although the news focused on Greece, investors also looked to other potential trouble spots in Europe, putting Italy in the spotlight. In response, iShares MSCI Italy (EWI) came under pressure. In February 2010, it was the second worst performing European ETF in the previous three months. Only the iShares MSCI Spain (EWP),
A market is hot, and then it is not. Therefore, investment opportunities pursued in a single country, particularly those in emerging markets, are often harvested over a period of months. They are not “buy and hold” investments for an autopilot type of investor. They require close daily monitoring.
On the other hand, a diversified international portfolio allows you to benefit more broadly from markets outside the US, without exposing yourself to undue risk in any one country. For most investors, this is the way to go.
Sector and Industry ETFs
Industry ETFs are a dynamic and growing market. Virtually every major industry group has multiple indices that track industry performance. The obvious advantage of sector ETFs is that they provide a means of investing in an entire industry; however, they can also be used for other purposes.
Sector ETFs invest in stocks and securities from specific industry sectors, such as energy, biotechnology, or chemicals. Most invest in US stocks, but more and more ETF providers are offering products that mimic the performance of global industry sectors. Finally, there are short and leveraged sector ETFs.
The main providers of sector ETFs are iShares, PowerShares, State Street, Vanguard and Merrill Lynch. In general, the cost of investing in large industrial sectors (such as health or energy) is less than the cost associated with more concentrated industries (such as oil services or nanotechnology).
Industry risk and reward
Historically, different industry sectors have exhibited different risk/reward characteristics. Broadly speaking, the technology sector tends to show the most volatility over time, while the utilities sector tends to be the least volatile. And, in general, individual sectors will show greater volatility than the stock market as a whole.
The hot sector strategy
Many investors look to sector ETFs as a means of profiting from the next hot sector. They recall, perhaps, the tech boom of the 1990s or the big jump in gold mining stocks in the early 2000s. The difficulty with this type of investing, of course, is that the hot sectors often go down. in price so fast (or faster) that they go up. Timing and risk management strategy is critical for investors using this approach.
Sector Rotation Strategy
Instead of looking for the next hot sector, a related strategy is to overweight the portfolio based on different phases of the business cycle. Studies indicate that various stock sectors tend to outperform the broader market at different phases of the business cycle. With this strategy, an investor can remain fully invested in the stock market, but will weight his or her portfolio based on each phase of the cycle.
Typically, in the early stages of an economic recovery, transportation and financial stocks tend to outperform the broader market. As the recovery takes hold and companies begin to invest more in operations, technology and capital goods stocks tend to benefit. In the later stages of the recovery, consumer goods, energy and precious metals stocks tend to outperform the market. When the economic recovery begins to run out of steam, so-called non-cyclical stocks, such as health and food, tend to outperform the broader market.
Of course, every economic environment is different and the markets always anticipate the next phase. Investors embarking on this strategy should do a lot of homework on the business cycle and be prepared to get slightly ahead of the real swings in the business cycle.
Diversified Sector Portfolio
The most widely accepted method of stock diversification is to build a portfolio consisting of a mix of small, mid, and large-cap stocks and a mix of growth and value strategies, using style ETFs. An alternative approach is to build a portfolio of sector ETFs that mimic the stock market in general. The advantage is that you can adjust the portfolio to your risk tolerance. For example, an aggressive investor might overweight the technology sector; a more conservative investor might overweight the utilities sector.
The downside to building a diversified portfolio in this way is that industry ETFs tend to cost a bit more than style ETFs. In addition, there are many studies that indicate that a portfolio with a slight weight in small-cap stocks and a value strategy tends to outperform the market as a whole. A sector-based portfolio will tend to be heavier in large-cap stocks and will split value/growth strategies equally. Of course, as with any trend based on market history, past performance is not necessarily indicative of future results.
Avoid Duplication of ETFs
If you’re already exposed to the broader stock market through a mix of style ETFs or a broad market index, it doesn’t make much sense to buy a large number of industry sector ETFs in a further search for diversification. The only thing that is done is to increase the overall cost of the investment.
However, using an industry sector ETF strategically may make sense if you want to slightly raise or lower your overall risk/reward profile in the context of your larger, more diversified portfolio. For example, to reduce risk, you could invest in a utility sector ETF. To take on more risk (and the potential for greater reward), you might want to invest in an energy or precious metals ETF.
Fixed income ETFs
Fixed income ETFs – especially in times of stress – can trade at huge premiums or discounts to their net asset values (NAVs).
ETFs typically trade at a price close to “fair value.” That is, if the intraday value of all the securities owned by an ETF were calculated, it would roughly match the price of the ETF.
The process that keeps ETFs trading at their “fair value” is the creation/redemption mechanism. If, at any time, the price of the ETF deviates from the price of the underlying portfolio, institutional investors can step in and arbitrage the difference.
Here’s how it works: If an ETF trades above its fair value, investors can buy the individual ETF shares and redeem them with the ETF issuer for new ETF shares at par. They can sell those shares on the inflated market, making a risk-free profit and helping bring the ETF’s share price back in line with the underlying securities. If an ETF is trading “cheap,” the process is reversed.
There are various ways and places in which this almost perfect relationship is altered. The most outstanding -and the most important- is that of fixed income. Fixed income ETFs – especially in times of stress – can trade at huge premiums or discounts to their net asset values (NAVs).
The question this article aims to answer is: “Is it a problem with the ETF or the underlying bond market?”
The Bond Market is Different
Compared to stocks — such as the S&P 500, which trade throughout the day on the New York Stock Exchange and the Nasdaq — bonds are relatively illiquid, and their true price is harder to know with certainty. For example, Apple stock is fungible, so the last price a stock traded at is a very good representation of the current value of each Apple share. The bond market is different.
- Bonds trade much less frequently than stocks, so the last traded price may not be current at all.
- They are not traded on an exchange: Most bond transactions are individual “over-the-counter” agreements between two parties.
- Bonds are much more varied than stocks; For example, Exxon has many bond issues, each with different maturities and coupons, and each requiring its own price.
- ETF issuers generally rely on bond pricing services to estimate the “fair” value of their holdings; these estimates are based on the current selling price the fund could receive if it were to start selling its bonds immediately. That selling price will always be less than what could be paid to buy the bond, so there is a “natural” depression in the declared net asset value of all bond ETFs.
For all of these reasons, it’s not uncommon for a highly liquid bond ETF to discover the true fair value price of the basket of bonds it owns. In other words, the bond ETF’s market price may be a better approximation of the aggregate value of the ETF’s underlying bond basket than its own net asset value. Therefore, large premiums and discounts do not necessarily indicate a misvaluation of the ETF.
The idea of price discovery – where the ETF’s market price is actually “ahead” of its net asset value and is the best representation of fair value – shows up in other corners of the ETF world. For example, imagine a Japanese equity fund. The underlying shares trade in Tokyo during trading hours, but the ETF trades throughout the US trading day. Negative news on Japan in the morning here in the US, after the Tokyo market closes, will depress the ETF’s share price, but its Net Asset Value will remain unchanged, resulting in a deep discount on that day.
To be clear, large premiums and discounts cannot be safely ignored in all cases, and ETF share prices are not always correct when they do not match the NAV. Sometimes large premiums and discounts indicate that the ETF itself is trading poorly and is therefore a lousy price discovery vehicle. Still, the relative illiquidity of the bond market means bond ETF premiums and discounts cannot be relied upon blindly.
A general rule of thumb: A bond ETF is likely to be an efficient price discovery vehicle—and therefore indicates that any large premium or discount is not a sign of trouble—if the ETF’s shares are traded with high frequency. and high volume.
Actively Managed ETFs
Here’s how actively managed ETFs differ from passively managed ETFs.
Funds like ETFs and mutual funds can help you build a diversified mix of investments. As the ETF market has evolved, different types of ETFs have been developed. They can be passive or active management. Passively managed ETFs attempt to closely track a benchmark (for example, a broad stock index such as the S&P 500), while actively managed ETFs attempt to outperform a benchmark.
There are two types of actively managed ETFs: traditional actively managed ETFs and the recently approved semi-transparent active equity ETFs. Let’s dive into traditional actively managed ETFs.
Actively Managed ETFs in the Spotlight
The underlying concept of an actively managed ETF is that a portfolio manager adjusts the investments within the fund as they wish, without being bound by the set rules of tracking an index, as a passively managed ETF attempts to do. The active fund manager aims to outperform a benchmark index using research and strategy. Traditional actively managed ETFs (as well as passively managed ones) report their positions daily and trade throughout the day. This is one of the differences between an actively managed ETF and a comparable mutual fund.
Perhaps because portfolio managers generally don’t want to disclose their next portfolio move for fear of early execution (i.e., a third party identifies and executes the same trade just before the fund executes its trade), managed stock ETFs actively have not proliferated to the extent of passively managed ETFs (see box on semi-transparent ETFs).
Potential Advantages and Disadvantages of Actively Managed ETFs
It’s important to understand the potential advantages and disadvantages of traditional, actively managed ETFs before considering one of these investment options. The advantages over other investments are as follows
- Potentially Higher Yields. While a passively managed ETF tries to track the performance of a benchmark index, actively managed ETFs have the opportunity to outperform the benchmark thanks to the investment decisions of portfolio managers and research analysts. Of course, the fund may also underperform the benchmark.
- Potentially lower cost than comparable funds. The structure of an actively managed ETF may allow you to have lower expenses than a comparable mutual fund.
- Tax efficiency. The process of creating and redeeming shares can make ETFs more tax efficient than a comparable mutual fund, since the process is done “in kind,” which is not a taxable event.
- Flexibility. Like index-based ETFs, actively managed ETFs allow investors to trade throughout the day, including shorting and buying on margin.3 This may also allow for greater liquidity for ETFs relative to long-term ETFs. funds that do not trade throughout the day.
Of course, traditional actively managed ETFs have drawbacks. Among them are:
- The daily disclosure obligation. This could be a problem for larger funds, as well as funds that hold illiquid securities. Full disclosure could hamper an active manager’s ability to make adjustments and apply a strategy with internal investment research in the portfolio, for fear of brokers and other operators in the market. Please note that semi-transparent ETFs do not have this requirement.
- Net Asset Value Deviation. Actively managed traditional ETFs can develop large premiums or discounts to NAV on volatile trading days. These ETFs may develop premiums/discounts to NAV that are higher than those of passively managed ETFs.
- Higher costs compared to certain funds. Although actively managed ETFs may have lower costs relative to comparable mutual funds, they may have higher expense ratios compared to index-traded ETFs.
An index-based ETF seeks to obtain the return of the market or subset of the market it seeks to replicate, less fees.
Most exchange-traded funds (ETFs) try to track the performance of an index. Therefore, knowing how those indices are built and maintained is an important part of choosing the right ETF investment.
There are two basic types of indices: those that track the broader market, such as the S&P 500 Index, and those that track a much more specific subset of the broader market, such as small-cap growth stocks or large-cap stocks. There are also indices on bonds, commodities and currencies.
An index-based ETF seeks to obtain the return of the market or subset of the market it seeks to replicate, less fees. Note that index-based ETFs do not track the underlying index perfectly; there is usually some level of tracking error, which is the difference between the market price of the ETF and the net asset value of the fund.
In general, indices based on a subset of the market are compared and compete with broader indices. Thus, investors often compare, for example, a small cap index, with a broader index on the global market.
Construction of Indexes
Indices are designed to measure, as accurately as possible, the value of a specific financial market or segment of that market. They are stable baskets of stocks, bonds, commodities, or other assets whose general level of price, risk, and return are used as standard measures around the world. The indices represent the universe of opportunities that all investors have to choose from at the weights that are actually available in the market. Every index must be easily replicable by an investor using the rules established by the index provider.
The securities in an equity index are generally passively selected and capitalization weighted. Typically, index providers include a wide selection of stocks and try to limit stock rotation. Some indices include all securities available in public markets, while others use a sample of those securities.
An index’s stock selection covers all stock exchanges. For example, the Standard & Poor’s, Morgan Stanley Capital International, Frank Russell & Company and DJ Wilshire equity indices present a good cross-section of stocks. These indices are made up of securities listed on the New York Stock Exchange (NYSE) and over-the-counter (NASDAQ).
Although each exchange has its own indices that measure the performance of securities primarily listed on that exchange, those strategy indices are not designed or intended to measure the value of the stock market in general, regardless of where those securities are listed. Equity indices are capitalization (cap) weighted. Each stock in a capitalization-weighted index is weighted in proportion to its market value relative to all other companies in the index. By default, a large company will have more influence on the performance of the index than a small company.
There are many types of cap-weighted indices, including fully-cap, free-cap, cap, and cash. The difference between full-cap and free-float is that the former includes the value of all outstanding securities, while the latter only includes the portion of securities that are available to individual investors.
They represent the shares held by shareholders who are free to sell. For example, an index of full-cap US large companies includes the market value of all outstanding Microsoft shares; A free-float index of large US companies does not include the market value of Microsoft restricted stock personally owned by company executives.
Liquidity ratios are a relatively new idea. Securities are weighted based on the number of shares that are regularly traded, rather than free float. The evolution of liquidity ratios is driven by emerging markets, where the liquidity of some issues is too low despite having a considerable number of shares outstanding.
Why should you consider an index-based ETF?
There is a school of thought, backed by a large body of research, that individual investors do better by investing in low-cost market indices and adjusting their allocation between stocks, bonds, and other assets based on their age and wealth. evolution of their risk/reward profiles. If you subscribe to this way of thinking, index-based ETFs can be very helpful.
Other advantages of broad index ETFs include:
- Less volatility than sector-specific and strategy-specific ETFs because they have a greater variety of securities
- The bid and ask spreads of the most popular index ETFs are usually quite small, so orders can be executed easily and efficiently.
- Index ETFs tend to be among the lowest cost ETFs because portfolio turnover and research costs are minimal.
Of course, no investment is without risk. With index-based ETFs, investors are tied to the performance of the underlying index. If the index misbehaves, so will the ETF. Also, not all ETFs that track the same index behave exactly the same. Due to tracking error, performance may vary, sometimes by up to half a percentage point. When selecting an index-based ETF, investors should weigh fees, liquidity, and tracking error before making a final decision.
Examples of Index ETFs
- IVV – (S&P 500 Index)
- ONEQ – Nasdaq Composite Index)
- FXI – (China FTSE Index 25)
- EWG – (German Index Fund)
ETF Premiums and Discounts
Although it seems confusing, ETFs have more than one “price”.
First, there is its real value, which is measured by the net asset value (NAV) at the end of each day and the intraday NAV (iNAV) in the middle of the day.
However, because ETFs are publicly traded, they also have a current market price, which may be higher or lower than their actual value.
In short, if the price of the ETF is trading above its NAV, the ETF is said to be trading at a “premium”. Conversely, if the ETF’s price is trading below its Net Asset Value, the ETF is said to be trading at a “discount.” In relatively calm markets, ETF prices and Net Asset Value are often close. However, when financial markets become more volatile, ETFs quickly reflect changes in market sentiment, while the net asset value can take longer to adjust, leading to premiums and discounts.
This can happen throughout the trading day, because the ETF and its underlying securities are actually two different liquidity pools that are only loosely linked.
If bullish investors start bidding aggressively on an ETF—rather than its underlying securities—the ETF’s price may rise faster than its underlying securities, and as a result, it may trade at a premium. Likewise, if bearish investors aggressively sell an ETF, more so than its underlying securities, the ETF may trade at a discount.
On the other hand, premiums or discounts may be due to the ETF and its underlying securities being traded on exchanges that are in different time zones.
Consider the case of ETFs listed on the New York Stock Exchange that track the FTSE 100. It is not uncommon for such ETFs to trade in significant volume after the London Stock Exchange closes at 11:30 am ET. The price of these ETFs will reflect real-time changes in market sentiment, while the net asset value will be based on old prices from the previous LSE close.
In this case, any significant deviation between the price of the ETF and the net asset value will probably disappear when both exchanges are open at the same time.
How are Premiums and Discounts Corrected?
Thanks to the creation/redemption mechanism, deviations between the ETF’s price and its net asset value are usually short-lived. That said, not all premiums and discounts are quick to self-correct; some persist for various reasons. In order for an authorized participant (AP) to quickly create or redeem shares, he needs to have access to the underlying securities, which is not always possible.
Sometimes access is just a timing issue: In the case of ETFs with international securities, there may be a delay before the PA can finally access the underlying market and actually create or redeem ETP shares, which can give give rise to temporary premiums and discounts.
Other times, restricted access to underlying securities could be a symptom of more serious structural problems. Depending on the severity, the issuer may even have to stop creating new ETF shares.
During the Arab Spring, for example, ETFs that tracked Egyptian markets were closed, causing a huge swing in the premiums received from those ETFs. In these cases, the ETF effectively begins trading as a closed-end fund, and can trade at constant premiums until creation resumes, at which point those premiums typically disappear.
The important thing to remember is that ETFs generally trade close to their fair value, and premiums or discounts tend to be short-lived. However, this is not always the case, so do more research before buying a fund simply because it is trading at a discount (you may have to sell at a higher discount). Lastly, use limit orders close to the net asset value to avoid buying at a large premium or selling at a large discount.
For individual stocks, liquidity has to do with trading volume. In the case of ETFs, there is something else to consider.
ETFs have two levels of liquidity: the liquidity of the underlying securities, ie the primary market, and the liquidity available in the secondary market. Although the factors that determine liquidity are not the same in the primary and secondary markets, both contribute to ensuring orderly trading of ETFs.
Broadly speaking, liquidity in the primary market is tied to the value of the ETF’s underlying securities, while liquidity in the secondary market is tied to the value of the ETF shares traded.
Liquidity in the Primary Market
One of the main characteristics of ETFs is that the offer of shares is flexible. That is, shares can be “created” or “reimbursed” to compensate for changes in demand. The creation and redemption of ETFs are aided by the liquidity of an ETF’s underlying portfolio of securities.
In the primary market, a specific type of entity known as an “authorized participant” (AP) can modify the supply of available ETF shares. The PA can download a large basket of shares (ie redeem) or purchase a large basket of shares (ie create) directly from the ETF issuer. Normally, the PA operates in the primary market to cover supply and demand imbalances that occur in the secondary market. Ultimately, the primary market helps provide additional liquidity in the secondary market.
Liquidity in the Secondary Market
Most ETF orders are entered electronically and executed in the secondary market, where bid and ask prices at which market participants are willing to buy or sell shares of the ETF are published. Secondary market liquidity is primarily determined by the volume of ETF shares traded.
To assess secondary market liquidity, follow an ETF at different times of the day, over various time periods, and see how it is affected by the market environment. Some of the statistics you can focus on are average bid-ask spreads, average trading volume, and premiums or discounts (ie, is the ETF trading close to its net asset value?).
ETF Liquidity Assessment
Most investors simply watch the liquidity of the secondary market. The key, however, is that both primary and secondary market liquidity play a role in providing a complete picture of ETF liquidity.
Although non-institutional investors tend to trade in the secondary market, retail investors and advisors can benefit from both primary and secondary market liquidity. Here is an example: If a high net worth investor trades tens of thousands of shares, he is likely to obtain liquidity through the primary market, since a PA satisfies that demand for liquidity.
Knowing more about liquidity in the primary and secondary markets can help you evaluate ETFs more strategically.
What Risks Do ETFs Have?
In general, ETFs do what they say they do. But to say that there are no risks is to ignore reality. Do your homework.
ETFs are bringing tremendous innovation to investment management, but like any investment vehicle, they are not without risk.
It is important for investors to understand the risks of using (or abusing) ETFs; Let’s review the top 10.
1. Market Risk
The biggest risk of ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are just an investment vehicle, a wrapper for your underlying investment. So if you buy an S&P 500 ETF and the S&P 500 is down 50%, the cheapness, tax efficiency, or transparency of an ETF won’t do you any good.
2. “The risk of” judging a book by its cover
The second biggest risk we see in ETFs is “judging a book by its cover.” With more than 1,800 ETFs on the market today, investors are faced with many options in any area of the market they choose. For example, the difference between the best performing biotech ETF and the worst performing biotech ETF is often huge.
Why? One biotech ETF may contain next-generation genomics companies seeking to cure cancer, while the other may contain tool companies serving the life sciences industry. Are both biotech? Yes. But they mean different things to different people.
3. Risk of Exotic Exposure
ETFs have done an amazing job opening up different areas of the market, from traditional stocks and bonds to commodities, forex, options strategies, and more. But is it a good idea to have easy access to these complex strategies? Not without doing homework.
In general, as you move beyond stock and bond ETFs, complexity reigns. Caveat emptor.
4. Tax Risk
The “exotic” risk is transferred to the tax area. The SPDR Gold Trust GLD contains gold bullion and tracks the price of gold almost perfectly. If you buy GLD and hold it for a year, will you pay the favorable long-term capital gains tax rate when you sell it?
I would if it was an action. But even if you buy and sell GLD like a share, you are still taxed based on what it contains: gold bullion. And from the perspective of the Internal Revenue Service, gold bullion is a “collector’s item.” That means you pay 28% tax no matter how long you have them.
Currencies get even worse treatment. Once again, going beyond stocks and bonds, caveat emptor.
5. Counterparty Risk
ETFs are, for the most part, safe from counterparty risk. Although alarmists like to scare stocklending activity within ETFs, it’s mostly nonsense: Stocklending programs are often overcollateralized and extremely safe.
The only place counterparty risk is very important is with ETNs. As explained in Exchange traded notes (ETNs), ETNs are simply unsecured debt notes backed by an underlying bank. If the bank fails, you’re stuck waiting in line with everyone else you owe money to.
6. Closure Risk
There are plenty of ETFs that are very popular, and there are plenty that are unloved. Every year, about 100 of these unloved ETFs are put out of their misery.
Closing an ETF is not the end of the world. The fund is liquidated and shareholders are paid in cash. However, it is not fun. The ETF will often realize capital gains during the liquidation process, which it will pay out to shareholders of record and which could create an unnecessary tax burden. There will also be transaction costs, uneven tracking, and various other grievances. One fund company even had the nerve to saddle shareholders with the legal costs of closing the fund (this is rare, but it did happen).
7. The Risk of Novelty
The ETF marketing machine is a powerful force. Every week—sometimes every day—the new, new thing comes out…one ETF to rule them all…one fund that will outperform the market with less risk, all while singing “The Star-Spangled Banner.”
Although there are many new ETFs coming onto the market, be wary of anything that promises a free lunch. Study marketing materials carefully, work to fully understand the underlying index strategy, and do not rely on any proven performance.
The general rule of thumb is that the amount of money invested in an ETF should be inversely proportional to the press it receives. That new social media/3D printing/machine learning ETF? It’s not for the core of your wallet.
8. Risk of Crowding
The “crowded trade risk” is related to the “novelty risk”. ETFs often open up small corners of the financial markets where there are investments that offer real value to investors. Bank loans are a great example. A few years ago, most investors hadn’t even heard of bank loans; today, more than $10 billion is invested in bank loan ETFs.
That’s all well and good… but be careful: As money rushes in, the appeal of a given asset can diminish. Also, some of these new asset classes have liquidity limits. If money runs out, profitability can be affected.
This is not to discourage anyone from bank lending, or emerging market debt, or low volatility strategies, or anything else. Just be mindful when buying: If this asset wasn’t a core asset in your portfolio a year ago, it probably should still be on the edge of your portfolio today.
9. ETF Trading Risk
Unlike mutual funds, you can’t always buy an ETF with zero transaction costs. Like any stock, an ETF has a spread, which can range from a penny to many dollars. Spreads can also vary over time, being small one day and wide the next. And worse, an ETF’s liquidity can be shallow: The ETF might trade a penny wide for the first 100 shares, but to sell 10,000 shares quickly, you might have to pay a quarter of margin.
Trading costs can quickly eat into your profitability. Understand the liquidity of an ETF before you buy, and always trade with limit orders.
10. Risk of ETFs
Most of the time, ETFs work the way they’re supposed to: happily tracking their indices and trading near net asset value. But sometimes something in the ETF breaks, and prices can go way off.
Often this is not the fault of the ETF. When the Arab Spring hit, the Egyptian Stock Exchange was closed for several weeks. The Market Vectors Egypt ETF (EGPT) was the only diversified and listed way to speculate on the opening of that market when things calmed down. During the close, Western investors were very bullish and moved the ETF up sharply from where the market was before the revolution. But when Egypt reopened, the market was basically flat, and the value of the ETF plummeted. It wasn’t the ETF’s fault, but investors got hurt.
We have also seen this in ETNs or commodity ETFs, when (for various reasons) the product has stopped issuing new shares. Those funds can trade at hefty premiums, and if you buy an ETF that trades at a significant premium, you should expect to lose money when you sell it.
In general, ETFs do what they say they do and do it well. But to say that there are no risks is to ignore reality. Do your homework.
Ultimately, one of the main reasons ETFs have seen significant growth – and will likely continue to do so – is because they are highly efficient investment vehicles. However, this does not mean that all ETFs are equally efficient, and therefore investors should evaluate a fund’s expense ratio, tracking results, and capital gains history when evaluating an ETF.
Ultimately, investors choosing an ETF should ask themselves three questions: What exposure does this ETF have? To what extent does the ETF offer this exposure? And how efficiently can I access the ETF? Look at the ETF’s underlying index (benchmark) to determine the exposure you’re getting. Evaluate tracking differences to see how well the ETF provides the intended exposure. And look for higher volumes and tighter spreads as an indication of liquidity and ease of access.