It is important to remember that ETFs are a structure. Investors are not used to having this type of transparency in their investments. Because the ETF’s components are transparent, the securities that actually define the value of the ETF will help investors understand how the ETF may act on the secondary market. In most other investment products, investors rarely ever see real-time pricing of the investment. They typically see either a daily, monthly or quarterly NAV, and they do not have to worry about the real-time pricing of the investment on a daily basis. It is important to remember that broad capital market weakness is broad capital market weakness—ETFs are not somehow immune to that. They are a wrapper that is priced via real-time calculations (if the basket is open) or via fair value models (expectations). The wrapper price is based on the underlying, ability to hedge, the cost involved in the hedge, and the costs to create/redeem. Broad, systematic weakness affects all products and structures. Understanding the primary market function can help investors understand how the ETF will behave on the secondary market during normal times, and how it may behave during times of severe market stress.
Zachary Hascoe is on the Capital Markets team at WisdomTree Asset Management. This post was republished with permission from the WisdomTree blog.
The content of this post is relevant to institutional investors interested in trading ETFs in significant size. Individual investors do not always have access to liquidity providers to trade ETFs.
1 — David Abner, The Visual Guide to ETFs (John Wiley & Sons, Inc, 2013), 91