Investors who are interested in investing with ETFs should consider an approach to achieve the best possible execution and an overall positive trading experience.
For example, many investors tend to look at a security’s liquidity to determine whether or not they will be able to execute an efficient trade. On the recent webcast (available On Demand for CE Credit), Mechanics of ETF Trading and Liquidity, Matt Lewis, Vice President and Head of ETF Implementation and Capital Markets, at American Century Investments, explained that to understand ETF liquidity, investors should consider the secondary market where ETFs trade, along with the ETF market depth and primary markets.
ETFs trade like a stock on an exchange with a bid-ask spread and exhibit an averaged daily volume. However, this is not the true indicator of an ETF’s overall liquidity. An ETF’s true liquidity is better determined through the creation and redemption mechanism through the help of a market maker.
Investors may also immediately focus an ETF’s spread or difference between the bid-ask to determine tradability. Lewis explained that spread is affected by a number of factors, including underlying securities, type of underlying securities, volume, day-to-day news events, creation costs and market volatility.
Since ETFs track a basket of underlying assets, investors may get a better sense of what they are paying for by comparing the ETF’s price to its net asset value, or NAV. Investors may also note that the ETF’s price may exhibit a premium or discount to its NAV.
To understand market depth, ETF traders may notice market makers post quotes that define the number of shares available at the market bid and ask. Additional shares may also be available through ETF block desks or by placing a limit order a few pennies below the bid or above the offer, Lewis added.
When looking at the behind the scenes action that makes ETFs work, investors should understand how they interact with the primary markets through the creation and redemption process to create new ETF shares. Lewis explained that the ETF creation and redemption process occurs when an investor enters an order to buy or sell a large number of ETFs shares and there are not enough shares available on the secondary market. Due to the innate creation and redemption process, ETFs are able to create and redeem shares based on supply and demand through the help of Authorized Participants whom work with ETF issuers and market participants to help provide more efficient or seamless ETF trades by providing the necessary ETF shares in case there are not enough on the secondary market.
Tidbits ETF Investors Should Keep In Mind
Beyond understanding the innate creation and redemption process that helps provide a clearer sense of an ETF’s liquidity, Lewis also outlined a number of other tidbits that ETF investors should keep in mind. For instance, investors should look at using limit orders when buying and selling ETFs; consider avoiding stop orders; use stop limit orders instead; avoid trading in the first 15 minutes of the market open or last 5 minutes of the trading session; try to trade ETFs with international exposure when those markets are open; leverage an ETF block desk for large orders; and speak with the ETF sponsor before buying or selling large quantities of an ETF.
Sandra Testani, Director of Product Management for Alternatives and ETFs at American Century Investments, argued that investors who are interested in intelligent beta and actively managed strategies designed to solve common investment problems and potentially enhance outcomes may consider something like the American Century STOXX U.S. Quality Value ETF (NYSEArca: VALQ) and American Century Diversified Corporate Bond ETF (NYSEArca: KORP).
While not actively managed, the STOXX U.S. Quality Value ETF incorporates a smart beta strategy reminiscent of actively managed investments and tries to reflect the performance of the iSTOXX American Century USA Quality Value Index, which is made up of 900 largest publicly traded U.S. equity securities screened and weighted by fundamental measures of quality, value and income. The portfolio is also dynamically allocated based on risk-adjusted return of value and income as a way to respond to changing market conditions.
The Diversified Corporate Bond ETF, though, is actively managed and integrate the insights of American Century Investment’s fundamental investing experts with the research methodologies of their Global Analytics Team. The fund invests in U.S. dollar-denominated corporate debt securities issued by U.S. and foreign entities, but may hold securities issued by supranational entities. Additionally, up to 35% of the fund’s net assets may be invested in high-yield securities or junk bonds. The fund may also invest in derivative instruments such as futures contracts and swap agreements.
Financial advisors who are interested in learning more about trading ETFs can watch the webcast here on demand.