Assuming that you always get a fair price, one clear advantage ETFs have over mutual funds is that you can sell your position at any point in the day. If you need cash, you can sell your ETF shares, generally get very quick trade execution, and know your exact proceeds. There is no need to wait until the end of the day for the mutual fund to report its net asset value and complete your redemption.
For long-term investors, the intraday liquidity of ETFs is more of a nicety than a necessity. In the grand scheme of asset allocation, a few hours of trading gains or losses will likely not impact your wealth. In fact, some investors find comfort in the fact that mutual funds always provide a "fair" price. You may not get your cash the second you want it, but at least your "trade" will be executed at the fund's net asset value. There is no winner or loser in the transaction--it should be an even-sum game where everyone gets the right price.
The arbitrage mechanisms behind ETFs generally keep them "fairly" priced, too, but some trading issues have arisen in certain situations that investors should be aware of. The good news is, we think there are quick remedies to help ensure your ETF trades work for you.
ETFs and APs
ETFs are typically very efficient. The market makers, called authorized participants, typically keep ETF prices very close to their net asset values as well. They are properly compensated for doing so. If ETF prices begin to stray from their "fair value," the authorized participant can perform an arbitrage to bring prices back in line. By buying up enough of the underlying stocks that make up an ETF, the AP can submit that share basket to the fund sponsor for shares of the ETF. Thus, if the ETF price is higher than its NAV, the AP can make a profit by buying up stock and exchanging the basket for ETF shares. The process works in reverse as well.
The catch is that the AP can create or redeem shares only when the basket reaches a size minimum, which is typically set at 50,000 or 100,000 ETF shares. For widely traded ETFs, such as SPDRs (SPY), the creation and redemption process can happen several times per day. The AP fully expects to be able to garner enough interest to clean his hands of any open position in a day or two. Thus, he'll likely be willing to trade with any client, large trade or small, for a price that is very close to NAV.
For smaller and less-heavily traded ETFs, there is a different trading dynamic. Large trades, those in 50,000 increments, can generally be executed very effectively. This seems counter-intuitive when compared with investing in small-cap stocks. Generally, the larger an order size for an illiquid or small market-cap stock, the larger the difference between the last quoted price and the actual price at which you will be able to execute a trade. The difference lies in the ability of the AP to neutralize his market exposure.
An investor wishing to invest a large enough sum of money, enough to trigger a creation event, can directly contact a specialist through the ETF firm and get the trade executed at a price very close to NAV. The authorized participant welcomes this trade because he or she will be able to complete the other side of the trade with the fund company. Conversely, very small trades can also be executed quickly and effectively. Investors looking to buy 100 shares can simply look at the posted bid and ask prices to see what prices they'll likely be able to fetch.
However, an interesting middle ground emerges that can occasionally be problematic for affluent individual investors and financial advisors. If you're executing a trade ranging from 1,000 to around 40,000 shares, your tactics should mirror stock-trading techniques. When bid and ask prices are posted, they are typically assigned volume limits. Thus, depending on the number of shares posted with the offering prices, only a portion of the shares you trade will likely be met at those prices. The rest of your lot will be met by the next few sets of bids, and those are typically at less-attractive prices. Of course, this applies only if you used a "market" order rather than a "limit."
In our ETF reports, we provide a general set of rules to help you pick out the best funds for your needs. Oftentimes, for two ETFs with similar market exposure and fees, we will recommend that investors go with the larger of the two funds because of its liquidity advantage.
Size and Liquidity
However, size and liquidity do not always go hand in hand. Sometimes an ETF can have considerable assets under management, but it may not be frequently traded. A parallel in the stock world would be a stock with a large market cap that has a small "float," such as Berkshire Hathaway (BRK.B). With a market cap exceeding $130 billion today, it would easily qualify for inclusion in the S&P 500 Index. However, its trading volume is light compared with many other S&P 500 constituents. Thus, it's excluded from the index. Its class B shares typically see average daily volume of around 50,000 shares. Compare that with General Electric (GE). Its market cap is closer to $100 billion, but more than 250 million shares change hands on a typical day. Clearly, Berkshire's $2,800-plus share price is partly responsible for the volume difference, but this example makes the point. It would be more difficult to move 40,000 shares of Berkshire than General Electric without moving market prices, and it has more to do with daily liquidity than market capitalization.
In the ETF world, we sometimes see a similar phenomenon with funds designed for long-term investors. For instance, take a look at Vanguard Dividend Appreciation ETF (VIG) and Vanguard Total World Stock Index ETF (VT). Both have considerable assets under management, at more than $1 billion and $190 million, respectively, so a $100,000 investment in either of these funds would hardly seem sufficient to move their respective market prices. However, we have heard reports from some investors that their purchase orders have been executed under a wide range of prices. These investors have placed larger-sized market orders and anticipated receiving prices close to the posted bids. Alas, parts of their orders have been filled at considerably higher prices than the indicated bid. To make matters worse, the bid typically comes back down after their order is filled, which leaves the investor feeling cheated. This is not a Vanguard-specific issue; Vanguard is merely a fund company that covets long-term investors over frequent traders.
This should not steer investors away from these products. Rather, investors should simply anticipate such events and take decisive action. Our solution to this problem is fairly simple: Use limit orders. These are great funds for long-term investors, but they are not the typical stomping ground of active traders. Thus, the market for these funds often exhibits a lack of willing sellers. Over the course of a few minutes or hours, a willing counterparty will likely emerge. If not, the authorized participant will capitulate to your limit price, so long as it is within reasonable range of the previously posted bid and NAV. Unless you need lightning-fast execution, make sure that you're getting the best price for your assets. Someone will eventually give you a "fair" price as long as your patience extends beyond this second. However, if you believe that getting NAV is more important than intraday liquidity, perhaps using a mutual fund is a better route for you. At least in the case of Vanguard, the choice is yours.
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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.
Paul Justice, CFA has a position in the following securities mentioned above: VIG. Find out about Morningstar's editorial policies.