ETFs are listed and traded like stocks, with their own bid/ask price, and the forces of supply and demand determine the current value at which someone may buy or sell an ETF. The spread between the bid/ask price mirrors the average spread of the underlying securities represented in an ETF, along with the traded volume and number of market makers.
The bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price at which a seller is willing to sell that same asset. As liquidity increases for a particular product, the spread will narrow, and a smaller spread is a reflection of a good product.
It should be noted that the price movements of an ETF’s underlying stocks mainly determine its pricing regardless of the fund’s trading volume during a given session. The spread may also vary across different asset classes, as a result of the liquidity within those funds.
Net Asset Value (NAV)
Investors shouldn’t focus on price alone but should also use complementary valuation methods. Investors looking at ETF performance over time as compared to the underlying index should look over net asset value (NAV).
NAV is the value of each share measured by the value of its underlying holdings and is calculated by using the closing prices of the underlying securities on their respective exchanges. The NAV is particularly useful in evaluating internationally-oriented funds, since global markets are open at different hours and the closing price will reflect a fund’s value at various points of the day. The NAV shows the last closing price on the relevant foreign exchange while the closing price of an ETF is listed as the fund’s last trade on a domestic exchange.
It should be noted that the NAV of funds that distribute dividends tend to grow when dividends are being paid out and will drop when the ETF holders are paid. The adjusted NAV of ETFs that reinvest the dividend is less critical to performance analysis.
The iNAV provide added transparency, credibility and valuation of a fund in real time to investors. It is suggested to compare the bid/ask price to the iNAV to see if an ETF is being priced fairly.
Your Trading Checklist
You’re ready to take the plunge and buy some ETFs for your clients’ portfolios. With this checklist, you won’t miss a beat:
- Find an ETF that’s in an uptrend – above its 200-day moving average. Determine the asset class, sector or global region where you want to invest and pull the ETF possibilities.
- Compare it to the others in its class on expense ratio, diversification and how well it fits with your existing holdings.
- Examine average trading volume and asset size. The size of the trading volume is relative to the size of the order you’re going to place; a good benchmark for assets is $100 million.
- Put your limit order in place to ensure that you’re not paying more than you should or want to.
- If it’s a low-volume fund with low assets, you have three options: 1) work the trade yourself in small increments, 2) call an alternate liquidity provider for help or 3) call your brokerage for assistance in getting the trade through.