ETFs were created with an innate creation/redemption process, but Paul points out that many financial advisors and institutions that Street One deals with may confuse the process when speaking in terms of “doing a creation unit” or “redemption unit,” which is not exactly how a trade execution process works.
The basic designs of an ETF allow investors to trade intraday, and if executed properly, they can enter or exit large positions with negligible price impact in terms of the underlying basket.
Due to the nature of the creation/redemption mechanism of ETFs, a number of firms are watching and waiting to take advantage of potential arbitrage opportunities where the underlying basket’s value – IIV, NAV or iNAV – may trade at a premium or discount to the ETF’s listed price via the bid/ask. Trading firms may buy or sell the underlying basket, take the other side of the trade through the ETF itself and “arb out” the price difference, which keeps trades close to the underlying values.
However, underlying baskets for fixed-income or commodity ETFs are harder to value, or harder to acquire, which may make those ETFs have higher bid/ask spreads or be harder to trade in terms of price impact or liquidity.
ETFs generally reflect their true underlying value, which makes them transparent and a more attractive investment for investors who aren’t content with closed-ended funds’ inherent discount/premium issues.
What should an advisor do if they have liquidity concerns?
Weisbruch vehemently urges advisors to never use market orders, regardless of what type of ETF they are planning to trade, and whether the ETF is heavily traded or one that trades lightly. Market orders may hurt a portfolio’s performance due to lost basis points on trades.
Limit orders are better alternatives, but there is a risk that an order won’t be filled. Weisbruch suggests contacting a trading desk for orders of 5,000 shares or more. “It pays from an advisor’s standpoint to make sure that the desk they are executing with truly understands ETF pricing nuances, and do not trade ETFs like they are closed-end funds of stocks, as it is fairly common for a general trading desk to be unfamiliar with ETF trade execution.”
Street One interacts with broker-dealer desks – Raymond James, Merrill Lynch, Morgan Stanley Smith Barney, Wells Fargo, etc. – on behalf of advisors as well as trading for RIAs through custody platforms – Fidelity, Pershing, Schwab, TD Ameritrade, etc. – to ensure optimal executions.
Liquidity providers and dedicated ETF trading desks will help advisors lock in those basis points with better executions, and maybe better portfolio performance numbers through better trading techniques.
Financial advisors also have the option of contacting their brokerage directly for guidance and assistance with trades.