For advisors who are more used to trading mutual funds, exchange traded funds (ETFs) might seem like a different animal altogether. While they bear some basic resemblance – mutual funds and ETFs are baskets of stocks – their differences are what make it so important to understand the way ETFs actually work.
The Markets Aren’t What They Used To Be
Sometimes, you have to take it elsewhere to get your trades through.
The existence of people who facilitate the process of trading ETFs by providing a market for even the most thinly-traded fund is opening up new worlds for advisors and investors, making it possible for them to invest in ETFs that they once feared would be illiquid.
While what they do isn’t new – they’ve been around more or less as long as ETFs have –there are more now than ever before. And just like ETFs have made it possible for investors to access futures, currencies and far-flung global markets that previously were only open to institutions, alternate liquidity providers have expanded beyond institutional clients to registered investment advisors (RIA) and financial advisors. The services of liquidity providers give these advisors better access to price discovery and execution.
David Abner, director of institutional ETF sales and trading at WisdomTree, is one such person. In answer to the sharp uptick in ETF interest on the part of RIAs, Abner has emphasized the point that advisors need to consider volume and liquidity as separate issues. “Volume is a backward looking number, calculated as what has traded in the past,” says Abner. “Liquidity is a forward looking number, a number that can be traded based on the underlying basket.”
On the execution side of ETFs, advisors should look at how to make the market in the ETFs, patiently wait for orders to get filled or look to get someone to execute the order in the underlying security, adds Abner. A basic ETF faux pas that Abner brings up is the use of market orders. It’s more prudent to use limit orders. However, there is always the question: Is the limit in range? Will someone fill my order?
The big issue in trading large blocks is in how to find someone to create volume based on the underlying liquidity. Just because an ETF is trading at low volumes doesn’t necessarily mean low liquidity. There is a lot of liquidity in the underlying baskets, but one needs to be able to successfully access it. Abner notes that liquidity represents the number of shares that can be traded in the underlying security. So, it is possible to shift around large quantities of cash in low volume ETFs, but one needs to be more creative in the process.