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6 ETF Questions Advisors Ask Most

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Many investment advisors today say that a key question they get from their clients is, “What does ETF stand for?” But David Mann, global head of ETF Capital Markets, Franklin Templeton Investments, moved beyond the basics into questions he gets from the firm’s clients, which include investment advisors and institutions. The answers can help explain ETFs to clients of all ilk. Here are the six key questions they hear, and their responses:

1. Is it possible to buy multiples of the average daily volume (adv) in one trade?

Yes, and the reason Mann stated during his presentation at the Morningstar ETF conference in Chicago, was there are two sources of liquidity for an ETF: from the underlying basket of securities the ETF is based on, and from the ETF itself.

“An ETF is a wrapper of an underlying basket of securities, whether of stocks or bonds, and even if the ETF doesn’t trade frequently, the underlying basket does,” Mann explained. “Liquidity drivers can leverage that so that it’s easy to trade any volume of an ETF. Looking at ADV to judge the merits of the product becomes somewhat less relevant because the underlying basket trades all the time.”

So despite his firm’s ETF products averaging about $67,000 per product a day, the underlying basket trades $23 billion per day. So just because a product has lower volume doesn’t mean you can’t buy larger size, he said.

2. Can I make a large purchase or sale in a small fund?

Often he’s found a merit of a fund will be determined by AUM size and ADV, and this question usually means: Will it limit a client’s ability to buy or sell?

“Size is not necessarily a gauge of liquidity,” he said. Digging down into the key concern is shareholder perspective: Should a client be concerned being a majority shareholder? Let’s say a fund has $5 million under management and a client wants to buy $3 million in shares; could that cause problems for him?

No, Mann said. “From an ownership perspective, because an ETF is little pieces of that underlying basket, even if you’re half the fund, you’re going to be a small owner of each of those securities.” Further, the creation/redemption process is designed to insulate existing shareholders from the actions of others, no matter the size of fund, he added.

3. Why is bid/ask spread not tighter?

  • Here he pointed out the factors that drive the bid/ask spread of an ETF, which include:
  • Cost of creating new shares that includes the impact of purchasing the underlying basket, the ETF creation fee, and any applicable taxes in a local market,
  • The cost of redeeming shares that may be different than the cost to create,
  • Market demand for ETF.

4. Why is my ETF trading away from its intraday net asset value?

Key to this, he says, is global pricing. An ETF has an end of day price, but the underlying keeps trading in markets around the world, and that can and often does push around the intraday pricing, but this price usually adjusts upon the next day’s opening session.

5.  What can cause a market flash crash?

 He said his firm still gets questions on the last big flash crash, in August 2015.

“ETF markets need certainty, so they either need the price calculated on underlying basket or something correlated to basket, like the index futures contract,” Mann said.  “If both of those are unavailable, we would expect wider quotes. That’s what happened two years ago. Futures were limit down, stocks were slow to open, market makers widened their quotes, and if market orders were submitted during that time of uncertainty, that’s when disconnected trading can happen.”

He also noted mini flash crashes can occur as well, for example during a big Federal Reserve announcement, but typically will move back once the fervor subsides. “The point is we don’t want to transact or trade when there are high levels of uncertainty in the marketplace, because that’s when flash crashes happen,” he said.

6. How do I avoid bad trades?

No doubt this is an “Every Trader” question. Mann said investors “should not confuse uncertainty with volatility. Volatility is not a problem, as we can trade up and down 1-2%, so volatility is fine because those market participants know how to price products. But uncertainty is when problems can happen.”

He said they provide these guidelines to this oft asked question:

1) Understand what’s normal in a product, such as ADVs and bid/ask spreads. “A good practice is know what the normal spread is” in any ETF, he said.

2) Consider a limit order to buy and sell. “Market orders can sometimes have unintended consequences,” Mann said.

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