The fast-growing ETF market offers investors many benefits: low fees, transparency and tax efficiency, but these funds are not without risks, which advisors should acknowledge and communicate to their clients.
The risks are similar to the risks associated with the typical stock because ETFs trade like stocks, with bid-and-ask spreads that result in a single market price, which changes throughout the trading day. Usually the spread is so tight that the price of the ETF, composed of multiple stocks or bonds, matches its NAV, but there have been instances when that wasn’t the case.
Take August 24, 2015, when the Dow fell more than 1,000 points in the first minutes of trading and the S&P 500 plunged more than 5%. At the same time iShares Core S&P 500 ETF (IVV) fell as much as 26% and the Power Shares S&P 500 Low Volatility ETF (SPLV) plunged as much as 46%.
Usually when an ETF’s share price falls below the total price of all its underlying assets, authorized market participants – typically a large financial institution — will buy ETF shares in bulk, exchange them for the underlying securities, then sell them for a profit. But on that late August day, many individual stocks weren’t available for purchase because S&P index futures plummeted before the open, triggering an NYSE procedural change that allowed floor traders to delay the opening in several stocks.
Bid-ask prices for stocks and ETFs widened and more trading pauses were triggered, which led to even more pauses. Trading in more than 320 ETFs was halted, including 10 that were halted multiple times.
“As the circle of investors and users of ETFs continues to expand the importance of understanding what they stand for grows commensurately,” says Ben Johnson, head of global ETF research at Morningstar.
There are currently about 1,900 U.S. ETFs with total assets topping $2 trillion and accounting for more than 60% of global ETF assets, according to ETFGI, an international financial research consulting firm.
1. Don’t Buy ETFs at the Market Open or Close
“An ETF holds a basket of securities. When securities inside don’t all trade the ETF’s price will deviate from the NAV,” explains Todd Rosenbluth, director of ETF and mutual fund research at CFRA. He recommends that investors not “blindly buy at the market open or close” because, though rare, something unexpected can happen, as it did on August 24.
There’s also no reason to trade ETFs held in a retirement or other long-term accounts at those potentially volatile times. Robo-advisor Betterment typically won’t allow investors to trade during the first 30 minutes of the market’s open and the last 30 minutes of its close because bid-ask spreads can be unusually wide at those times.
2. Trade ETFs When the Underlying Market Is Open
Timing is also a factor for trades of international or global ETFs, whose underlying shares include securities trading outside the U.S., possibly in different time zones. “If you are trading an ETF that invests in securities that trade in markets outside the United States, it’s best to trade the associated ETF when its constituents are actively changing hands in his home market,” according to a recent Morningstar report penned by Ben Johnson, who heads the firm’s Global ETF Research.
For a European ETF that means trading in the morning because then U.S. and European markets overlap. There is no such opportunity for trading a Japanese ETF because there were are no overlapping hours.
3. Use Limit Orders
The U.S. investor who wants to trade shares of a Japanese ETF can limit the potential volatility of that move by using a limit order for the trade. If the investor is buying those shares the limit order means the price will be at that level or lower; if the trade is for selling shares the limit order will be at that particular price or higher, but there is no guarantee the trade will be executed.
Johnson recommends that investors use limit orders for all ETF trades where time, not price, is the most important consideration. He says this is especially important for ETFs that are not very liquid, unlike the SPDR S&P 500 ETF (SPY), and there are many of those. The top 100 of the 1900 ETPs trading today control about 75% of that market’s $2 trillion-plus AUM.
”It may take a longer than a market order but it may potentially not get completely filled but those “costs need to be weighed against the cost of being exploited by an opportunities market maker looking to pick off market orders in thinly traded ETFs,” writes Johnson.
4. Talk to an ETF Rep When Making Big Trades
The best way to avoid poor execution of a big ETF trade – which Johnson defines as equal to about 20% of an ETF’s average daily volume or more than 1% of its AUM – is to talk with the representative of the ETF’s capital market’s team or a market maker in the ETF, says Johnson.
“All ETF sponsors are willing to take calls from investors who need help in executing a trade to make sure those trades are cost effective and as expedient as possible,” says Johnson.
5. Consider Buying a Mutual Fund Instead
Investor who don’t require the intraday liquidity that ETFs provide should consider buying an index mutual fund if the instruments track the same index and carry comparable costs. “If you place no value on intraday liquidity and you would prefer to forgo navigating the ins and outs of ETF trading, then an index mutual fund tracking the same benchmark is likely a better choice for you,” says Johnson.
Those investors might even save some money because many index mutual funds can be purchased for no fee while many ETF purchases — though not all — involve commissions.
In addition, the SEC recently approved rules, effective in 2018, that require mutual funds to maintain a minimum percentage of easy-to-sell assets to meet potential investor demand. Illiquid assets are limited to 15% of total AUM. The liquidity rules set for many ETFs were less restrictive.
— Related on ThinkAdvisor: