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ETFs: 4 Things Advisors Should Know Before Buying

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ETFs have become more popular among financial advisors than mutual funds because they cost less, are more tax-efficient and are transparent about their holdings and price throughout the day. In comparison, mutual funds are priced only once daily, after the market closes.

But all these advantages don’t necessarily mean ETFs will perform better than mutual funds. Their performance can be influenced by factors not readily apparent to advisors, according to a new white paper by Pershing and its parent BNY Mellon released this week entitled “What Lies Beneath: Understanding the Structure and Costs in ETFs.”

“Because more assets are going into ETFs we wanted advisors to know the different costs that go into ETF pricing,” says Justin Fay, a vice president for alternative investments and ETFs at Pershing. “ETFs are not always the right choice for a particular strategy.”

These are the four factors that advisors should consider when choosing ETFs for clients, according to the Pershing white paper:

Expense ratios

1. Expense ratios. The cost of owning an ETF tends to be lower than the cost of owning a mutual fund simply because trading costs for the ETF’s underlying securities are borne by market makers, not the fund itself as is the case for mutual funds, explains Brian Brennan, VP of global ETF product management at BNY Mellon, in the white paper.

But he warned that expense ratios for complex ETFs such as leveraged and inverse ETFs and master limited partnerships (MLPs) are not necessarily low. The ProShares Ultra Dow30 ETF (DDM), designed to have twice the daily performance of the Dow Jones Industrial Average, for example, has an expense ratio of 95 basis points, which is not untypical for a leveraged long or short index ETF.

“Too many advisors focus on expense ratios and minimize other important factors,” according to the Pershing paper. “Although total expense ratios are important there are other things to consider during a cost-comparison analysis.”

Bid-Ask Spreads

2. Bid-Ask Spreads. Among those other things to consider when buying an ETF are the bid-ask spreads, one of the “greatest factors in the total cost of ownership,” according to Terri Mayle, director of global trading solutions at Pershing, who’s quoted in the white paper. These spreads affect the transaction costs of ETFs, and not mutual funds, since ETFs trade throughout the day.

The more liquid the ETF — i.e., the more it trades — the narrower the spread, and the smaller the impact on transaction costs. Brennan recommends that advisors and investors evaluate bid-ask spreads when choosing between similar ETFs. The Meaning of Commission-Free

3. The Meaning of Commission-Free. “Much as been made recently of the advent of commission-free ETFs, which sound great, but could involve ETFs with wide bid-ask spreads,” according to the white paper. A no-transaction fee ETF could actually cost more than one that isn’t free IF it has a lower trading volume and therefore a wider spread, Mayle noted.

“Ultimately, the spread that really matters is the one paid at the time of the transaction,” says Mayle. “That cost must be weighed against, more than anything, investment goals and objectives.”

Fay notes that advisors should be “mindful” that commission-free ETFs, while seemingly cheaper, could compensate by having higher expense ratios.

Tracking Errors

4. Tracking Errors. This is the risk investors face when the price of an ETF deviates from the price of its benchmark. It’s more common with foreign and emerging market ETFs because of the difference in time zones with the U.S.  When such an ETF is trading in the U.S., overseas markets are often closed, which can make it difficult to “establish the fair value of emerging market ETFs,” says J.C. Mas, managing director and head of ETF and portfolio trading at BNY Mellon Capital Markets.

“In effect the implied liquidity that benefits most ETFs won’t be as readily available for hard-to-trade ETFs [tied to] closed markets,” says Mas. “This is not an indictment of non-US based ETFs.… It’s simply a cautionary note that some of the myriad of benefits offered by ETFs can’t be perfectly expressed in all products.”

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