ETFs can be thought of as mutual funds that are listed on exchanges but that doesn’t mean they trade exactly like individual stocks.
Without understanding the inner workings of the ETF investment vehicle and the underlying securities that the funds track, investors can incur unforeseen costs beyond the fee in basis points, writes Ari Weinberg for Pensions & Investments.
“The implementation of a trade is very important and, in some cases overlooked,” Tim Coyne, head of ETF capital markets for State Street Global Advisors, said in the article.
“While the depth of the limit order book for an ETF tends to be much deeper than for common stocks, liquidity is also more volatile,” Milan Borkovec, managing director and head of financial engineering at ITG, said in the story.
For starters, market makers, or Authorized Participants, create or redeem new ETF shares to help keep trades fluid. When creating new shares, they would purchase a bulk of underlying securities and deliver them to a fund custodian for new units of the ETF, which typically represent 25,000 to 50,000 shares of the ETF. [Creation and Redemption]
In a recent paper titled “Create or Buy,” ITG found that the “optimal switching point” between secondary market orders to creating new shares from underlying stocks depends on the characteristic of the ETF. In general, large bulk orders can be cheaply accessed through new shares, costing investors 2 to 4 basis points less.
However, pushing in large orders can cause additional headaches as trading a large sum too quickly can push up an index and its underlying stocks.
“A lot of ETFs are quoted by market-making algorithms,” Chris Hempstead, director of ETF Execution at WallachBeth Capital, said in the article. “If the quotes fill in around your trade (back to the original price), you probably paid too much.”
“You should have a sense of the maximum amount you would pay before the trade, including commissions and convenience charges,” Matt Hougan, president of ETF Analytics for Index Universe, added.
Reginald M. Browne, managing director for listed derivatives at Knight Capital Group, suggests that investors should combine a mix of both market-maker on a secondary market and an authorized participant creating shares of the fund while also considering alternative ETFs that offer similar exposure.
For more information on trading ETFs, visit our ETF 101 category.
Max Chen contributed to this article.