Anyone can access exchange traded funds through a brokerage account. However, financial advisors should understand the inner workings of the ETF structure to implement cost-effective trades.
On the recent webcast, The Secret to ETF Trading: Understanding ETF Liquidity, Edward A. Rosenberg, Senior VP and Head of ETF Capital Markets & Analytics at Northern Trust Asset Management, reviewed best practices and common misconceptions regarding best executions in ETF trades.
While ETFs, like company stocks, trade on the stock exchange and can be accessed through a normal brokerage account, the funds are not driven exclusively by supply and demand but have an intrinsic value and are driven by the value of the underlying securities, Rosenberg explained.
Some traders may point to an ETF’s low trading volume and automatically assume the ETF is illiquid. However, since ETFs represent a basket of securities, an ETF’s true liquidity is based on the overall liquidity of its underlying holdings.
“ETFs always have more than one level of liquidity,” Rosenberg said.
For instance, in the secondary market, investors mya compare the volume and “on-screen” bid/offer data to gauge liquidity. Additionally, market makers provide further ETF market depth as they source liquidity for investors by allocating trades that are just pennies off the bid/ask price in the secondary market. Lastly, in the primary markets, ETF providers and Authorized Participants may identify additional liquidity through the ETF creation/redemption process.
The creation and redemption process helps facilitate large block trades in an ETF with low trading activity.
“The ETF creation process occurs when an investor enters an order to purchase a large number of ETF shares and there are not enough available shares on the secondary market,” Rosenberg said.