Watch those bid-ask spreads
One advantage ETFs have over funds is that you can sell your position at any point in the day
The arbitrage mechanisms behind ETFs generally keep them 'fairly' priced, too, but some trading issues have arisen in certain situations that investors should be aware of. The good news is we think there are quick remedies to help ensure your ETF trades work for you.
ETFs are typically very efficient. The market makers, called authorised participants, typically keep ETF prices very close to their net asset values as well. They are properly compensated for doing so. If ETF prices begin to stray from their 'fair value,' the authorised participant can perform an arbitrage to bring prices back in line.
The catch is that the AP can create or redeem shares only when the basket reaches a size minimum, which is typically set at 50,000 or 100,000 ETF shares. For widely traded ETFs, such as SPDRs, the creation and redemption process can happen several times per day. The AP fully expects to be able to garner enough interest to clean his hands of any open position in a day or two. Thus, he’ll likely be willing to trade with any client, large trade or small, for a price that is very close to NAV.
For smaller and less-heavily traded ETFs, there is a different trading dynamic. Large trades, those in 50,000 increments, can generally be executed very effectively. This seems counterintuitive when compared with investing in small-cap stocks where large orders will blow bid-ask spreads sky high. With ETFs, an investor wishing to invest a large enough sum of money, enough to trigger a creation event, can directly contact a specialist through the ETF firm and get the trade executed at a price very close to NAV.
However, an interesting middle ground emerges that can occasionally be problematic for affluent individual investors and financial advisers. If you’re executing a trade ranging from 1,000 to around 40,000 shares, your tactics should mirror stock-trading techniques. When bid-ask prices are posted, they are typically assigned volume limits. Thus, depending on the number of shares posted with the offering prices, only a portion of the shares you trade will likely be met at those prices. The rest of your lot will be met by the next few sets of bids, and those are typically at less-attractive prices. Of course, this applies only if you used a 'market' order rather than a 'limit.'
In the ETF world, size and liquidity do not always go hand in hand—especially with funds designed for long-term investors. For instance, take a look at Vanguard Dividend Appreciation ETF and Vanguard Total World Stock Index ETF. Both have considerable assets under management, so a $100,000 investment would hardly seem sufficient to move their respective market prices. However, we have heard reports from some investors that their purchase orders have been executed under a wide range of prices. These investors have placed larger-sized market orders only to find parts of their orders being filled at considerably higher prices than the indicated bid. To make matters worse, the bid typically comes back down after their order is filled, which leaves the investor feeling cheated. This is not a Vanguard-specific issue; Vanguard is merely a fund company that covets long-term investors over frequent traders.
This should not steer investors away from these products. Rather, investors should simply anticipate such events and take decisive action. Our solution to this problem is fairly simple: Use limit orders. These are great funds for long-term investors, but they are not the typical stomping ground of active traders. Unless you need lightning-fast execution, make sure that you’re getting the best price for your assets.
