From the February 2014 issue of Investment Advisor • Subscribe!

A New Practitioner’s Guide to ETFs

If you’re thinking about adding ETFs to a client’s portfolio, start here

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A month removed from both the holiday season and year-end tax adjustments for client portfolios, the time to follow through on lingering New Year’s resolutions to add ETFs for client portfolios is now. There are a number of items to assist the transition, but it helps by organizing them into two primary areas: making the investment decision and trading (buying and selling shares).

Investment Decision Process

This is the easier part. Utilize the same process for evaluating mutual funds. Avoid getting preoccupied comparing index, smart beta and active ETFs. Instead, examine the specifics of an investment strategy to uncover critical information. For example, determine how much developed versus emerging markets exposure an international ETF may hold.

Indexes have different construction processes, and of course, an active ETF manager can use discretion to effectively implement an investment strategy—subject to the prospectus’ limitations. Reviewing a manager’s experience remains essential. For most ETFs, that can be discovered in the construction of an index. Remember that smart beta is still an index, and the manager cannot make changes to improve a strategy’s performance. As many active ETFs are new, learning a portfolio manager’s history of managing money is important.

New ETFs should not necessarily be avoided. Advisors typically want to carefully watch how a manager performs and adheres to an investment strategy before making an allocation. Unlike mutual funds, ETFs provide daily transparency and intraday liquidity that ensures a manager is constantly holding the types of securities expected for an investment strategy. Plus, factor in no redemption fees—only the commission costs to exit an ETF anytime desired.

Trading

Treat an ETF trade like buying or selling an individual stock, and always use limit orders. It is a good best practice to follow. Anyone working an order can be aggressive about the limit order’s placement. However, advisors familiar with the “place it and forget it” order process of NAV-based mutual fund trading may want to consider using a marketable limit order. For example, if an ETF trades at an asking price of $25.17, then a limit order placed at $25.19 should ensure an entire order gets filled, still likely at the $25.17 asking price.

The indicative value of an ETF—which measures the intraday NAV in real time—may not always represent the best value of the price. The indicative value usually gives just an estimate of the ETF value in certain asset classes. Examples include international equity, for which the underlying holdings are not actively priced during the U.S. market open; and high yield, where the bonds are liquid, but do not trade often. Market makers, and the prices that other investors are willing to buy and sell at, usually represent the ETF’s most appropriate value or fair value.

Another trading item of guidance: Do not fear low-volume ETFs. ETFs are structured as “open-end” funds, which means they can create an unlimited amount of shares and redeem as many shares outstanding. Therefore, an ETF’s true liquidity exists with its underlying positions rather than its trading volume.

In trading low-volume ETFs, practice the following: Call the ETF sponsor directly and inquire if they can assist with placing the trade and helping facilitate the best price. It’s that simple. The one area where ETFs differ from stocks is that more efficient pricing becomes available with size. Unlike with stocks, market makers can create new shares with an ETF sponsor, easily handling large purchases or sales with the absence of risk.

Be mindful of these simple, yet important exercises when navigating the ETF marketplace, and may those resolutions stay on track.

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