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T H E M A G A Z I N E F O R E T F I N V E S T O R S ////////////////////////////////////////////////////
B:9” JANUARY 2020
T:8.75”
A D V E R TS:8”
ISEMENT
look to
the future
together
Invesco Distributors, Inc.
Access the Nasdaq 100 all in one ETF.
Leverage each and every breakthrough, from some of
the world’s most groundbreaking companies.
invesco.com/qqq
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more greatly impacted by market volatility, than more diversified investments.
The Nasdaq-100 Index comprises the 100 largest non-financial companies traded on the Nasdaq.
Before investing, investors should carefully read the prospectus and carefully consider
the investment objectives, risks, charges and expenses. For this and more complete
information about the Fund, call 800 983 0903 or visit invesco.com.
Invesco Distributors, Inc.
THE MAGAZINE FOR ETF INVESTORS JANUARY 2020
The Possibility Of
Fractional Shares
An ETF Primer
Glossary of ETF Terms
A Legend Retires
Canada In Focus
T:10.75”
B:11”
S:10”
ETF UNIVERSITY
THE
EDUCATION
ISSUE
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VO L U M E 2 0 | N O . 1
Contents
F E AT U R E S
12 ETF University: Promise Of Fractional ETF Shares
Fractional ETF shares could be a game changer for the proliferation of ETFs
By Lara Crigger
16 ETF University: Getting Started
A primer on what investors should know before they invest in ETFs
By ETF.com Staff
32 Jim Ross: A Legend Retires
One of the driving forces behind the first U.S. ETF heads into the sunset
By Cinthia Murphy
36 2020 Canada Supplement
An overview of the Canadian ETF market, plus a directory of key contacts
DE PART ME NTS
PUBLISHER, GLOBAL HEAD OF SALES
Noel d’Ablemont Smith
nsmith@etf.com 6 E
TF Launches: FCPI Sectors In Review
52
MANAGING DIRECTOR Fidelity ETF targets stocks Sector ETFs had a great month, with
Dave Nadig benefiting from inflation most seeing positive returns
dnadig@etf.com
REPRINT SALES
sales@etf.com
ETF Explainer: IHF
8 Countries In Review
54
A health care provider ETF had a Most emerging markets took a hit
EDITOR
Drew Voros
wild 12-month ride during November
dvoros@etf.com
MANAGING EDITOR Data At A Glance
10 ETF Data
56
Heather Bell A look at the performance of Our monthly databank breaks down
COPY EDITOR Saudi Arabia, fixed income ETF and ETN returns for every market
Lisa Barr and small caps vs. large caps segment
HEAD OF DESIGN
Patrick Hamaker Industry Insight
48 The Last Word
66
ETF.com How small institutions use ETFs ETF.com Managing Director Dave
17 State Street, 32nd Floor Nadig on understanding new
New York, NY 10004
www.ETF.com Commodities In Review
50 investors’ qualms
November was a mixed month for
commodity ETFs
© 2020 ETF.com. All rights reserved. The text, images and other materials contained or displayed are proprietary to ETF.com, except
where otherwise noted, and constitute valuable intellectual property. No material from any part of any ETF.com publication, product,
service, report, email or website may be downloaded, transmitted, broadcast, transferred, assigned, reproduced or in any other way
used or otherwise disseminated in any form to any person or entity, without the explicit written consent of ETF.com. For permission
to photocopy and use material electronically, please contact sales@ETF.com or call 646-558-6985.NEW FUNDS By Heather Bell
ETF
Launches
3% ETF FILING ACTIVITY
ASSET ALLOCATION
LAUNCHES
3% 1%
INTL FIXED INCOME COMMODITIES U.S. EQUITY
Fidelity Stocks for Inflation
5% 1% FT Cboe Vest US Equity Buffer - Aug
INVERSE ALTERNATIVES
FT Cboe Vest US Equity Buffer - Nov
FT Cboe Vest US Equity Deep Buffer - Aug
FT Cboe Vest US Equity Deep Buffer - Nov
220
6% Innovator S&P 500 Buffer - Nov
LEVERAGED Innovator S&P 500 Power Buffer - Nov
38%
ETFs
Innovator S&P 500 Ultra Buffer - Nov
17% US EQUITY MicroSectors FANG+ ETN
US FIXED INCOME YEAR TO DATE ProShares Russell US Dividend Growers
ProShares S&P Tech Dividend Aristocrats
U.S. FIXED INCOME
AAM Low Dur Preferred/Income Sec
WisdomTree Mortgage Plus Bond
25% INT’L EQUITIES
INT’L EQUITY Defiance Next Gen Food/Ag ETF
SmartETFs Smart Transportation/Tech
F E AT U R E D E T F
INVERSE
Direxion Daily Dow Jones Internet Bear 3X
Fidelity Stocks For Inflation ETF (FCPI) Direxion Daily S&P 500 High Beta Bear 3X
New fund seeks to target sectors and stocks that do well as inflation rises LEVERAGED
Direxion Daily Dow Jones Internet Bull 3X
In November, Fidelity launched an equity increasing inflation.
Direxion Daily S&P 500 High Beta Bull 3X
ETF that is supposed to outperform the FCPI tracks the Fidelity Stocks for Infla-
broad market in times tion Factor Index, which has a structural ASSET ALLOCATION
Quick View
of increasing infla- tilt toward inflation-sensitive sectors. The Strategy Shrs Newfound/ReSolve Robust Momntm
ISSUER Fidelity
tion via a factor-based index selects its roughly 100 components
SEGMENT Equity: U.S. - Total Market strategy. The Fidelity based on their factor scores from the larg- SELECTED CLOSURES
EXPENSE RATIO 0.29% Stocks For Inflation est 1,000 stocks in the U.S. market. Cushing Energy & MLP
ETF (FCPI) tracks an Components are equal weighted, with Cushing Energy Supply Chain & MLP
STRUCTURE Open-Ended Fund
index of large and mid- their weights then adjusted upward if they Cushing Transportation & MLP
INCEPTION 11/5/2019 Cushing Utility & MLP
cap U.S. stocks offering fall into certain sectors such as energy,
GraniteShares S&P GSCI No K-1
exposure to the value, quality and momen- materials, consumer staples, health care,
InsightShares LGBT Employment Equality
tum factors. real assets and infrastructure.
InsightShares Patriotic Employers
FCPI comes with an expense ratio of In early December, the fund included
Xtrackers Barclays Intl Corp Bond Hedged
0.29% and lists on Cboe Global Markets, Microsoft, LyondellBasell Industries and
Xtrackers Barclays Intl Treasury Bond
the parent company of ETF.com. Steel Dynamics among its largest com-
Xtrackers FTSE Emerging Compr Factor
The fund aims to capture the perfor- ponents.
Xtrackers MSCI South Korea Hedged
mance of companies in segments of the FCPI joins Fidelity’s family of 28 ETFs, Xtrackers Russell 2000 Compr Factor
market that have typically exhibited above which have a total of $2.7 billion in assets
average performance during times of under management.
Source: ETF.com. Data and information as of 11/30/2019. ETF Filings sidebar covers launches and closures for the month of November 2019.
6 ETF.com/ETF Report+ Independent perspective
+ Unrivaled liquidity
There’s more to it
World-leading
market indices + Unsurpassed credibility
S&P Dow Jones Indices has achievedADVERTISEMENT
iconic status for good reason.
+ Powerful methodologies
spdji.com/indexology
Copyright © 2019 S&P Dow Jones Indices LLC. All rights reserved. S&P® and Indexology® are registered trademarks of Standard & Poor’s Financial Services
LLC. Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. It is not possible to invest directly in an index. S&P Dow Jones Indices
receives compensation for licensing its indices to third parties. S&P Dow Jones Indices LLC does not make investment recommendations and does not
endorse, sponsor, promote or sell any investment product or fund based on its indices.I N D E TA I L By Heather Bell
ETF Explainer: IHF
iShares U.S. Healthcare Providers ETF
Each month, we look at an ETF selected by ETF.com based on its performance and importance to investors. This month,
we consider the performance of the $883 million iShares U.S. Healthcare Providers ETF (IHF), which covers U.S. companies
offering health care services. All the companies mentioned below are holdings in IHF, unless otherwise noted (*).
RETURN
5%
Quick View 1.53%
ISSUER BlackRock
0 Equity: U.S. Health Care
SEGMENT
FEB Providers & Services
20
EXPENSE RATIO 0.43% JUL
JAN 11 NOV
AUM $883 Million
-5 30 6
COMPETING FUND XHS
-10
SEP
5
-15
APR
16
-20
-25
DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV
2019
JAN Anthem exceeds expectations for its fourth-quarter revenue JUL UnitedHealth Group’s stock rises more than 5% after the
30 and earnings, and issues a better-than-expected earnings
forecast, boosting its stock significantly.
11 Trump administration walks back its proposed plan to halt
the rebates paid to insurance companies by drugmakers.
FEB CVS’ stock price plunges after the company issues a lower-than- SEP Cigna announces a plan to fully cover gene therapy treatments
20 expected earnings forecast for 2019. The expectations suggest
CVS is still dealing with the challenges of its Aetna acquisition.
5 and provide increased access for its members to the expensive
therapies, sparking a multiday increase in its stock price.
APR HCA Healthcare’s share price sinks more than 10% on NOV Humana reports strong third-quarter results, exceeding
16 worries that Medicare-for-all legislation promoted by multiple
presidential candidates could damage the company’s future.
6 analyst expectations, and says the layoffs of 800 employees
announced previously were part of a cost-saving effort.
Source: Bloomberg. Data for 11/30/2018 to 11/30/2019.
8 ETF.com/ETF ReportIncome Rooted
in Strength.
DURA
®
VanEck Vectors Morningstar
Durable Dividend ETF ADVERTISEMENT
Approach dividend investing from a position of strength. Powered by Morningstar’s forward-looking
research, DURA provides exposures to companies with high dividend yields, financial strength, and
attractive valuations.
Call us at 800.826.2333 vaneck.com/durabledividend
Morningstar, Inc. does not sponsor, endorse, issue, sell, or promote the VanEck Vectors Morningstar Durable Dividend ETF and bears no liability with respect to that ETF or any security.
An investment in the Fund may be subject to risks which include, among others, investing in the consumer staples, energy, health care, and utilities sectors, small and medium-
capitalization companies, equity securities, dividend paying securities, market, operational, high portfolio turnover, index tracking authorized participant concentration, no guarantee of
active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, non-diversified, and concentration risks, which may
make these investments volatile in price or difficult to trade.
Fund shares are not individually redeemable and will be issued and redeemed at their net asset value (NAV) only through certain authorized broker-dealers in large, specified blocks of
shares called “creation units” and otherwise can be bought and sold only through exchange trading. Shares may trade at a premium or discount to their NAV in the secondary market.
You will incur brokerage expenses when trading fund shares in the secondary market. Past performance is no guarantee of future results.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Funds
carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com. Please read it carefully
before investing.
Van Eck Securities Corporation, Distributor, 666 Third Avenue, New York, NY 10017DATA AT A G L A N C E Compiled by Heather Bell
M O N T H LY F LOWS INTERESTING CHARTS OF PAST 12 MONTHS
Below are the ETFs that experienced the top and bottom flows for the month The below graphs highlight some of the key
of November, as well as the net flows for major asset classes during the month. ETF trends of the past 12 months.
TOP GAINERS
TICKER FUND ISSUER NET FLOWS ($M) AUM ($M) iShares MSCI Saudi Arabia ETF KSA
IEFA iShares Core MSCI EAFE ETF BlackRock 2,520.53 71,405.73
VS. iShares Core MSCI Emerging Markets ETF IEMG
VOO Vanguard S&P 500 ETF Vanguard 1,836.48 126,826.59 KSA started strong during the 12-month period, outperforming IEMG until
XLF Financial Select Sector SPDR Fund SSGA 1,448.48 26,297.78 a September drone attack on some of its oil processing facilities.
SPY SPDR S&P 500 ETF Trust SSGA 1,358.82 286,459.89 RETURN
30%
EWJ iShares MSCI Japan ETF BlackRock 1,353.90 14,486.37 25
QUAL iShares Edge MSCI U.S.A. Quality Factor ETF BlackRock 1,119.97 15,207.97 20
15
AGG iShares Core U.S. Aggregate Bond ETF BlackRock 1,059.71 67,184.97
10
VYM Vanguard High Dividend Yield ETF Vanguard 1,037.42 28,465.83 5
0
SIZE iShares Edge MSCI U.S.A. Size Factor ETF BlackRock 1,008.14 1,456.95
-5
BND Vanguard Total Bond Market ETF Vanguard 940.38 47,468.50 -10
D J F M A M J J A S O N
2019
BIGGEST LOSERS
TICKER FUND ISSUER NET FLOWS ($M) AUM ($M) Vanguard Total Bond Market ETF BND
VS. iShares 20+ Year Treasury Bond ETF TLT
SDY SPDR S&P Dividend ETF SSGA -1,164.79 19,700.10
TLT iShares 20+ Year Treasury Bond ETF BlackRock -953.89 17,699.91 The broad bond market has exhibited impressive performance during the
past 12 months, but TLT’s long-term exposure has driven even better returns.
GLD SPDR Gold Trust SSGA -891.71 41,914.72
RETURN
IVV iShares Core S&P 500 ETF BlackRock -691.67 197,046.03 35%
SPLV Invesco S&P 500 Low Volatility ETF Invesco -681.18 12,462.59 30
MDY SPDR S&P Midcap 400 ETF Trust SSGA -663.87 18,967.48 25
20
SCHO Schwab Short-Term U.S. Treasury ETF Charles Schwab -579.46 5,164.70
15
VCIT Vanguard Intermediate-Term Corporate Bond ETF Vanguard -570.54 25,266.54
10
JNK SPDR Bloomberg Barclays High Yield Bond ETF SSGA -561.01 9,907.28 5
USMV iShares Edge MSCI Min Vol U.S.A. ETF BlackRock -450.87 36,516.49 0
D J F M A M J J A S O N
2019
ASSET CLASSES
NET FLOWS ($M) AUM ($M) % OF AUM SPDR S&P 500 ETF Trust SPY
VS. iShares Russell 2000 ETF IWM
U.S. Equity 15,994.72 2,448,894.38 0.65%
International Equity 13,360.50 855,288.42 1.56% Although they were neck and neck at the start of the past 12 months,
small cap IWM has fallen behind large cap SPY in terms of performance
U.S. Fixed Income 6,695.95 747,526.34 0.90% during the course of the year.
International Fixed Income 2,979.69 87,917.62 3.39% RETURN
20%
Commodities -1,128.27 78,315.69 -1.44% 15
10
Currency -89.37 1,406.05 -6.36%
5
Leveraged -207.12 37,588.18 -0.55% 0
Inverse 578.5 12,087.98 4.79% -5
-10
Asset Allocation 52.05 10,551.20 0.49%
-15
Alternatives 229.52 4,637.02 4.95% -20
D J F M A M J J A S O N
2019
Sources: FactSet, Bloomberg; data as of 11/30/2019
10 ETF.com/ETF ReportWhether you’re a novice or seasoned
The Fight For Fractional
ETF investor, our comprehensive educational ETF Trading 12
library is the perfect place to learn about ETFs
What Is
an ETF? 16
Compiled by the ETF.com Staff
What Is
an ETN? 17
Why Are ETFs
So Tax Efficient? 18
What Is the Creation/
Redemption Mechanism? 19
What Are Authorized
Participants? 20
Understanding
Premiums & Discounts 21
Managing & Avoiding
ETF Closures 22
Understanding
Securities Lending 23
Understanding
Spreads & Volume 24
Understanding
ETF Liquidity 25
Legal Structures,
Regulations & Taxes 26
THE
Understanding
EDUCATION VIX ETFs 27
ISSUE
ETF
Fixed Income ETFs
During a Panic 28
Why You Can’t
Buy Spot Oil 29
Glossary
30
UNIVERSITY
of Terms
JANUARY 2020 11ETF UNIVERSITY
EASY FOR MUTUAL FUNDS
For a decade or longer, fractional trading has been some-
thing of a holy grail for the ETF industry, a deceptively
simple concept that’s been exceedingly difficult to put into
The
practice. The reason strikes to the heart of what differenti-
ates mutual funds from ETFs.
Although mutual funds and ETFs are pooled invest-
ment vehicles, investors can only buy in or sell out of
mutual funds once per day, after the close of market hours.
Fight For
Once the mutual fund’s net asset value (NAV) is calcu-
lated, based on the closing prices of all the securities in
its portfolio, the fund manager then creates and redeems
shares of the fund in cash. This means any investor want-
ing to buy shares gives their cash to the manager, who
Fractional
then creates exactly the amount of shares determined by
the NAV. For example, your $150 would buy 1.5 shares of a
mutual fund whose NAV is $100.
As a result, fractional shares of a mutual fund can and
very often do arise, simply to make the bookkeeping work.
ETF Trading
And there’s no problem with execution, because every in
and out transaction happens via the fund company itself.
ETFs, however, are exchange-traded, meaning
their shares are listed on exchanges, and exchanges
don’t allow investors to buy partial shares of securi-
ties. Whether you’re an authorized participant building
a new ETF creation unit or a retail investor purchasing
I
n October, discount brokerage Charles shares through their brokerage, you simply can’t buy
Schwab made waves when it announced it fractional shares of an ETF, no more than you could buy
planned to introduce trading of fractional fractional shares of Amazon (AMZN).
stock shares in 2020, as part of a broader
effort to entice younger investors to its platform. ETFs HAVE A LOWER INVESTMENT THRESHOLD
Fractional ETF shares, however, aren’t yet in Usually this isn’t a problem, given that the bar for invest-
the cards. ment in ETFs tends to be lower than for mutual funds.
“We are … exploring how fractional share Typically, ETF investment minimums are much lower than
trading could be applied in other areas, such as those for mutual funds, which can cost $1,000, $3,000 or
with ETFs, but our focus right now is on individual even $10,000 per share. Even individual stocks can get
stocks,” Schwab spokesperson Erin Montgomery pricy; for example, Berkshire Hathaway (BRK) currently
told ETF Report. costs a whopping $326,100 per share.
Fractional trading is considerably more difficult
to implement for ETFs than it might at first appear,
and it remains one of the last clear advantages
mutual funds have over their exchange-listed cous-
ETFs WITH THE HIGHEST PRICE PER SHARE FIGURE 1
ins. Because mutual funds can be bought and sold in
TICKER FUND PRICE PER SHARE
partial shares, they’ve managed to retain dominance
in 401(k)s and other retirement accounts, of which MDY SPDR S&P Midcap 400 ETF Trust $360.87
roughly half of all Americans have. ONEQ Fidelity NASDAQ Composite Index Tracking Stock $333.18
So what makes fractional ETF trading so difficult,
IVV iShares Core S&P 500 ETF $309.85
and is there any way to simplify it for the masses?
FLGE Credit Suisse FI Large Cap Growth Enhanced ETN $308.17
Or is the best solution simply not to bother?
SPY SPDR S&P 500 ETF Trust $308.05
Source: ETF.com; data as of 12/3/19
12 ETF.com/ETF Report
12Still, for investors with smaller asset prices or precise accessed outside the context of a brokerage account. This
target allocations, per-share prices of ETFs can get hefty, means that if a client wants to transfer funds to another
especially for the largest and most liquid legacy ETFs account or liquidate assets, they’ll likely lose their frac-
with high brand recognition. Several of the top 10 larg- tional holdings. The partial shares may then be converted
est ETFs are also among the most expensive; the most to cash or even sold, at which point the investor would be
expensive-per-share ETF is the SPDR S&P Midcap 400 on the hook for any resulting capital gains.
ETF Trust (MDY), which currently costs $361/share (see Finally, the unavoidable truth is that no matter how
Figure 1). small a slice of a share is offered, it still may not be pre-
Therefore, fractional trading of ETFs would not only cise enough for some investors’ needs. For example,
allow sophisticated investors to more precisely replicate 1/10,000th of one share of MDY is about $0.04, mean-
ETF model portfolios, but it would also allow investors ing an investor who wants to trade in chunks smaller than
with smaller asset bases to start building broadly diversi- that will have to accept some rounding error, however
fied portfolios. small it may be.
Fractional ETF trading can also improve the efficiency
of tax-loss harvesting, while avoiding the cash drag on USE ETFs IN 401(k)s?
returns introduced by the remainder of an investor’s These risks aside, partial-share ETF trading opens up
assets that cannot be invested in whole shares. investment to the lowest-asset-base investors, encourag-
ing market participation at younger ages.
SOME FRACTIONAL ETF TRADING AVAILABLE It also makes it easy to regularly invest small amounts
Some brokerages already allow for partial-share owner- of cash, i.e., dollar cost averaging—such as that done
ship of ETFs by inserting themselves as a sort of middle- through biweekly paycheck contributions. Therefore, if
man: They bundle all the necessary trades across their and when brokerages like Schwab decide to offer frac-
various client accounts, then they buy and sell in lots of tional ETF trading, it could dramatically improve the
whole ETF shares, as needed. Those shares are then put attractiveness of using ETFs in employer-offered 401(k)
in a collective trust, shares of which can then be redistrib- plans, for example.
uted to their clients on a fractional basis. However, trading commissions could still chip away at
M1 Finance, for example, allows investors to invest in the utility of fractional ETF trading in 401(k)s, given that
fractional amounts of ETFs as granular as 1/10,000th of a in some or many cases, a $4.95 or $9.95 buy/sell cost sig-
share. Other independent brokerages, like Stockpile and nificantly outstrips the price of the underlying fractional
Social Finance, also allow fractional ETF trading, as well as ETF share. Yet the industry appears to be shifting more
some robo advisors like Betterment. and more to commission-free trading; in recent months,
In addition, in November, J.P. Morgan quietly rolled out Interactive Brokers, TD Ameritrade, E*Trade and Schwab
fractional ETF trading for some users of its You Invest robo have dropped commissions on all trades.
platform, making the service available to accounts with That said, the real solution to the aforementioned
less than $5,000 in ETFs and cash. problems of cash drag and imprecise investment alloca-
tions might not be fractional ETF trading at all, but the
FRACTIONAL ETF TRADING RISKS de-bundling of securities from the ETF packaging entirely,
Allowing fractional ETF trading requires a certain amount through direct indexing.
of scale, however, while also introducing some risks. Via fractional stock ownership, direct indexing allows
Since the firm must trade in whole lots, it will assume investors to precisely allocate their cash to the securities
some risk in owning the “leftover” fractions of ETFs— of an index, without the use of any pooled investment
though if the brokerage trades in enough bulk, that risk vehicle. Until recently, direct indexing was only available
may be small. to the highest-asset investors. But newer services, such as
Furthermore, there’s a cost to managing the trust into Orion, bring this technique to advisors and investors with
which the whole ETF shares are placed. Usually it’s only lower and lower asset bases.
on the order of a few basis points, but that can add some If direct indexing takes off in retirement accounts,
cash drag. fractional ETF trading may indeed become a true holy
In addition, since fractional trading is tied to a collec- grail: a once-prized treasure that everybody’s given up
tive trust managed by the brokerage, generally it can’t be seeking.
JANUARY 2020 1314 ETF.com/ETF Report
JANUARY 2020 15
ETF UNIVERSITY Compiled by ETF.com Staff
WHAT ABOUT ETFs?
All that’s great, but you want to learn about ETFs.
What Is
So what is an ETF? Well, it’s a mutual fund too. It’s a pooled
investment vehicle that offers diversified exposure to a particular
area of the market. It can invest in stocks, bonds, commodities,
currencies, options or a blend of assets. Investors buy shares,
which represent a proportional interest in the pooled assets.
It’s a mutual fund in every aspect … except one.
And that’s a big one, which is hinted at in its very name:
an ETF?
exchange-traded funds.
BEING EXCHANGE-TRADED
You buy shares in an ETF directly from any brokerage account.
Just like you buy shares in a stock, you can enter a buy order
in your Schwab or Fidelity account and buy any ETF you want.
You can also do it whenever you want. Whereas orders to
buy or sell a traditional mutual fund can be processed only once
per day (after the close of trading), ETF trades can take place
any time the market is open. You can buy shares in the morning
and sell them in the afternoon. You can buy them at 10 a.m.,
Offering low-cost access to virtually every corner
sell them at 11 a.m. and buy them again after lunch if you want.
of the market, ETFs allow investors big and small
You can also perform all sorts of stocklike strategies with
to build institutional-caliber portfolios with lower
ETFs that you never could with mutual funds: selling short,
costs and better transparency than ever before.
placing stop-loss or limit orders, even buying on margin.
But what exactly is an ETF? And how does it
And that’s just the beginning: The fact that ETFs are
provide these benefits?
“exchange-traded” creates a series of other benefits that, accord-
ing to many market observers, make them a better overall choice
LIKE MUTUAL FUNDS … BUT NOT
than traditional mutual funds for many reasons: lower costs, bet-
To understand how ETFs work, the best place to start is with
ter tax efficiency and more. Of course, in other situations, they
something familiar, like a traditional mutual fund.
can be worse: commissions, trading spreads and other risks.
Imagine half a dozen investors, sitting at home, each try-
In sum, an ETF is a tool that allows investors to access
ing to figure out the best way to invest in the stock market.
different corners of the market—everything from U.K. equi-
They could each go out and buy a few stocks on their own,
ties to Chinese tech stocks to high-yield bonds, spot gold
but who has the time or resources to manage a portfolio of
bullion and more—at low costs, from the comfort of a tradi-
50 or 100 stocks?
tional brokerage account.
Instead, they decide to band together. They pool all of
It’s like a mutual fund 2.0.
their money and hire a professional investment manager to
invest it for them.
To keep track of who invested what, each investor receives
“shares,” representing their stake in the total investment. LARGEST ETFs BY AUM
Because it’s your money, you want to know how much TICKER FUND ER AUM
your investment is worth … every day. So every day, the SPY SPDR S&P 500 ETF Trust 0.09% $279.75B
mutual fund tallies up the value of everything it owns and
IVV iShares Core S&P 500 ETF 0.04% $196.23B
divides it by the number of shares that exist. Presto whammo:
VTI Vanguard Total Stock Market ETF 0.03% $131.99B
You know exactly what each share is worth.
If you want to buy more shares, you know the amount VOO Vanguard S&P 500 ETF 0.03% $125.69B
of cash to send the mutual fund for each share. If you want QQQ Invesco QQQ Trust 0.20% $83.20B
to sell shares, you know exactly how much cash to expect
VEA Vanguard FTSE Developed Markets ETF 0.05% $75.96B
in return.
It’s an elegant system, and mutual funds have existed IEFA iShares Core MSCI EAFE ETF 0.07% $70.82B
for close to 100 years. They currently provide exposure to AGG iShares Core U.S. Aggregate Bond ETF 0.05% $66.17B
stocks, bonds, commodities and other assets. VWO Vanguard FTSE Emerging Markets ETF 0.12% $63.49B
EFA iShares MSCI EAFE ETF 0.31% $61.94B
Source: FactSet; data as of 11/20/2019
16 ETF.com/ETF Report
16ETF UNIVERSITY
LARGEST ETNs BY AUM
Investors typically use the term “ETF” to mean
TICKER ETN EXP RATIO AUM
a lot of things that aren’t technically “exchange-
traded funds,” a roster that includes the exchange- AMJ JPMorgan Alerian MLP Index ETN 0.85% $2.45B
traded note (ETN), which is the most important of FLGE Credit Suisse FI Large Cap Growth Enhanced ETN 1.52% $1.82B
these additional structures. FIHD UBS AG FI Enhanced Global High Yield ETN 1.65% $1.80B
ETNs are debt notes issued by a bank. When you buy an FBGX UBS AG FI Enhanced Large Cap Growth ETN 1.29% $1.33B
ETN, the bank promises to pay you a certain pattern of return.
FIYY Barclays ETN+ FI Enhanced Global High Yield ETN Series B 0.93% $1.21B
If you buy an ETN linked to the price of gold, for instance, the
FRLG Large Cap Growth Index-Linked ETN 1.46% $1.20B
value of that ETN will increase if the gold price goes up.
The beauty of the ETN structure is that it can be linked to VXX iPath Series B S&P 500 VIX Short Term Futures ETN 0.89% $1.01B
anything. There are ETNs that track commodities, and ETNs UGAZ VelocityShares 3X Long Natural Gas ETN 1.65% $910.38M
that track hard-to-reach corners of the equity market. They TVIX VelocityShares Daily 2x VIX Short-Term ETN 1.65% $894.14M
sometimes combine stock or bond positions with options
MLPI ETRACS Alerian MLP Infrastructure Index ETN 0.85% $889.10M
overlays, or use other sophisticated strategies that would be
difficult to package into a traditional ETF. In the commodity
Source: FactSet; data as of 11/20/2019
space, the ETN also offers significant long-term tax advan-
tages compared with most ETFs.
The downside of an ETN is that if the underlying bank
goes bankrupt, you lose essentially all of your money. There
were, for instance, a few ETNs backed by Lehman Brothers.
While most investors in Lehman’s ETNs fled before the firm
shut down, anyone who held to the bitter end probably still
has a bad taste in their mouth.
The good news is that this credit risk in most situations is
What Is
minor. Institutional investors can “redeem” (get their money
back) from the underwriter of ETN daily. While anything can
happen, you usually see major bank defaults coming more
than a day or two ahead.
The even-better news is credit risk is easily monitored.
FactSet monitors and reports on the credit risk of every ETN
an ETN?
daily, and the data appears on the ETF.com website. The data
provider does that by watching the cost of credit default
swaps (CDS) on the underwriting banks each day. CDS are
like insurance—investors buy them to protect themselves
against a company’s default—so they are the best possible
view of the likelihood a bank will go down.
How do you check? Just pull up the Efficiency Tab on any
ETN (e.g., www.etf.com/AMJ) and check out the ETN Coun-
terparty Risk measure. If it says “Low,” you’re OK. If it says
“High,” run for the hills.
JANUARY 2020 17ETF UNIVERSITY
ETF issuers each day publish the lists of what securities
an authorized participant (AP) must deliver to the ETF to cre-
ate new shares (“creation baskets”), as well as what shares
they’ll get if they redeem shares from the ETF (“redemption
Why
baskets”). This—combined with the ability to see the full
holdings of the index an ETF is aiming to track—provides an
extremely high level of disclosure even for those few ETFs
that fall short of the daily-disclosure ideal.
GREATER TAX EFFICIENCY
Are ETFs
ETFs are vastly more tax efficient than competing mutual funds.
If a mutual fund or ETF holds securities that have appreci-
ated in value, and sells them for any reason, they will create a
capital gain. These sales can result either from the fund sell-
ing securities for a tactical move, due to a rebalancing effort,
or to meet redemptions from shareholders. By law, if funds
So Tax
accrue capital gains, they must pay them out to shareholders
at the end of each year.
Generally, ETFs do much better than actively managed
mutual funds.
Why? For starters, because they’re index funds, most
ETFs have very little turnover, and thus amass far fewer
Efficient?
capital gains than an actively managed mutual fund would.
But they’re also more tax efficient than index mutual funds,
thanks to the magic of how new ETF shares are created and
redeemed.
When a mutual fund investor asks for her money
back, the mutual fund must sell securities to raise cash
to meet that redemption. But when an individual investor
wants to sell an ETF, he simply sells it to another investor
T
wo of the great, underappreciated advantages like a stock. No muss, no fuss, no capital gains transaction
of ETFs are their transparency and tax for the ETF.
efficiency. Compared with mutual funds, ETFs And when an AP redeems shares of an ETF with an issuer,
are light years ahead in these two critical it actually gets even better. When APs redeem shares, the
categories. ETF issuer doesn’t typically rush out to sell stocks to pay the
AP in cash. Rather, the issuer simply pays the AP “in kind”—
BETTER TRANSPARENCY delivering the underlying holdings of the ETF itself. No sale
One of the key benefits of ETFs is that they offer better means no capital gains.
transparency into their holdings than competing mutual The ETF issuer can even pick and choose which shares to
funds. The ability to verify your positions on a daily basis (in give to the AP—meaning the issuer can hand off the shares
most cases) is a big plus. with the lowest possible tax basis. This leaves the ETF issuer
By law and by custom, mutual funds are only required with only shares purchased at or even above the current mar-
to disclose their portfolios on a quarterly basis—and then ket price, thus reducing the fund’s tax burden and ultimately
only with a 30-day lag. Mutual funds can and do stray from resulting in higher after-tax returns for investors.
their described targets—a phenomenon known as “style The system doesn’t work so smoothly for all ETFs. Fixed-
drift”—which can negatively impact an investor’s asset income ETFs, which have more turnover and often have cash-
allocation plan. In short, when you buy a mutual fund, based creations and redemptions, are less tax efficient than
you’re taking a leap of faith—and in the past, investors their equity brethren.
have been burned. But all else equal, ETFs win hands-down, with two
ETFs are far more transparent. By custom, most—but not decades of history showing they have the best tax efficiency
all—ETFs disclose their full portfolios on public, free web- of any fund structure in the business.
sites every day of the year.
18 ETF.com/ETF Report
18ETF UNIVERSITY
T
he key to understanding how ETFs work is remove money from the fund.
the “creation/redemption” mechanism. It’s With ETFs, APs do most of the buying and selling. The
how ETFs gain exposure to the market, and is AP pays all the trading costs and fees, and even pays an
the “secret sauce” that allows ETFs to be less additional fee to the ETF provider to cover the paperwork
expensive, more transparent and more tax efficient involved in processing all the creation/redemption activity.
than traditional mutual funds. The beauty of the system is that the fund is shielded
It’s a bit complicated, but worth understanding. from these costs. Funds may still pay trading fees if they
have portfolio turnover due to index changes or rebalances,
WHY IT’S IMPORTANT but the fee for putting new money to work (or redeeming
The creation/redemption process is important for ETFs in a money from the fund) is typically paid by the AP. (Ultimately,
number of ways. For one, it’s what keeps ETF share prices investors entering or exiting the ETF pay these costs through
trading in line with the fund’s underlying NAV. the bid/ask spread.)
Because an ETF trades like a stock, its price will fluctuate The system is inherently more fair than the way mutual
during the trading day, due to simple supply and demand. If funds operate. In mutual funds, existing shareholders pay
many investors want to buy an ETF, for instance, the ETF’s the price when new investors put money to work in a fund or
share price might rise above the value of its underlying departing investors sell their shares, because the fund bears
securities. the trading expense. In ETFs, those costs are borne by the
When this happens, the authorized participant can jump AP (and later by the individual investor looking to enter or
in to intervene. Recognizing the “overpriced” ETF, the AP exit the fund).
might buy up the underlying shares that compose the ETF
and then sell ETF shares on the open market. This should
help drive the ETF’s share price back toward fair value, while
What Is the
the AP earns a basically risk-free arbitrage profit.
Likewise, if the ETF starts trading at a discount to the
securities it holds, the AP can snap up 50,000 shares of that
ETF on the cheap and redeem them for the underlying secu-
rities, which can be resold. By buying up the undervalued
Creation/
ETF shares, the AP drives the price of the ETF back toward
fair value while once again making a nice profit.
This arbitrage process helps to keep an ETF’s price in line
with the value of its underlying portfolio. With multiple APs
watching most ETFs, ETF prices typically stay in line with the
Redemption
value of their underlying securities.
This is one of the critical ways in which ETFs differ from
closed-end funds. With closed-end funds, no one can cre-
ate or redeem shares. That’s why you often see closed-end
funds trading at massive premiums or discounts to their
Mechanism?
NAV: There’s no arbitrage mechanism available to keep sup-
ply and demand pressures in check.
The ETF arbitrage process doesn’t work perfectly, and it
pays to make sure your ETF is trading at fair value. But most
of the time, the process works well.
EFFICIENT WAY TO ACCESS THE MARKET
The other key benefit of the creation/redemption mecha-
nism is that it’s an extraordinarily efficient and fair way for
funds to acquire new securities.
As discussed, when investors pour new money into
mutual funds, the fund company must take that money and
go into the market to buy securities. Along the way, they pay
trading spreads and commissions, which ultimately harm
returns of the fund. The same thing happens when investors
JANUARY 2020 19ETF UNIVERSITY
market demand, it turns to an AP, which may be a market
maker, a specialist or any other large financial institution.
Essentially, it’s someone with a lot of buying power.
It is the AP’s job to acquire the securities that the ETF
wants to hold. For instance, if an ETF is designed to track the
S&P 500 Index, the AP will buy shares in all the S&P 500
constituents in the exact same weights as the index, then
deliver those shares to the ETF provider. In exchange, the pro-
vider gives the AP a block of equally valued ETF shares, called
a creation unit. These units are usually formed in blocks of
50,000 shares.
The exchange takes place on a one-for-one, fair-value
basis. The AP delivers a certain amount of underlying securi-
ties and receives the exact same value in ETF shares, priced
based on their net asset value (NAV), not the market value at
which the ETF happens to be trading.
Both parties benefit from the transaction: The ETF pro-
vider gets the stocks it needs to track the index, and the AP
gets plenty of ETF shares to resell for profit.
The process can also work in reverse. APs can remove
ETF shares from the market by purchasing enough of those
shares to form a creation unit and then delivering those
shares to the ETF issuer. In exchange, APs receive the same
What Are
value in the underlying securities of the fund.
HOW DO APs GAIN THE RIGHT TO CHANGE
THE SUPPLY OF ETP SHARES?
ETP issuers decide. Prior to launch, the issuer will designate
Authorized
one or more AP to the fund. More can sign up over time. The
most popular ETFs will have dozens of APs.
HOW DO APs IMPACT LIQUIDITY?
An AP’s ability to create and redeem shares helps keep ETFs
Participants?
priced at fair value.
For example, if demand for an ETF increases and a pre-
mium develops, APs step in to create more shares and push
the ETF’s price back in line with its actual value. If there’s a
rush to sell and a discount develops, APs buy ETF shares on
the open market and redeem them with the ETF issuers to
reduce supply.
Generally, the greater the number of APs for a particular
A
uthorized participants (APs) are one of ETF, the better: The force of competition is more likely to keep
the major parties at the center of the ETF the ETF trading close to its fair value.
creation/redemption mechanism, and as such, The task set forth for an AP is not necessarily an easy
they play a critical role in ETF liquidity. In one: Sometimes the underlying market that they must
essence, APs are ETF liquidity providers that have access to change the supply of ETF shares is illiquid, or
the exclusive right to change the supply of ETF just difficult to access. An exchange-traded product track-
shares on the market. ing the S&P 500 will be easy to access and easily hedge-
able for most APs, while one tracking, e.g., Nigeria equi-
ROLE OF AUTHORIZED PARTICIPANTS ties will be tough.
When an ETF company wants to create new shares of its Mostly, APs are invisible to individual investors and advi-
fund, whether to launch a new product or meet increasing sors. Still, it’s good to know they’re there.
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20ETF UNIVERSITY
C
onfusing as it seems, ETFs have more than one not always possible.
“price.” Sometimes access is just a time challenge: For ETFs hold-
First, there’s its actual value, which is ing international securities, there could be a delay before the
measured by net asset value (NAV) at the AP is finally able to access the underlying market and effec-
end of each day and by intraday NAV (iNAV) in the tively create or redeem ETF shares—the delay can lead to
middle of the day. temporary premiums and discounts.
However, because ETFs trade on an exchange, Other times, restricted access to the underlying securi-
they also have a current market price—which could ties could be symptomatic of more serious structural prob-
be more or less than its actual value. lems. Depending on the severity, the issuer may even have to
In short, if the price of the ETF is trading halt the creation of new ETF shares.
above its NAV, the ETF is said to be trading at a During the Arab Spring of 2010, for instance, ETFs track-
“premium.” Conversely, if the price of the ETF is ing the Egyptian markets shuttered, leading to wild swings
trading below its NAV, the ETF is said to be trading in the perceived premiums of those ETFs. In these cases,
at a “discount.” the ETF effectively starts trading like a closed-end fund, and
In relatively calm markets, ETF prices and NAV can trade at constant premiums until creations are resumed,
are generally close. However, when financial markets when such premiums usually vanish.
become more volatile, ETFs quickly reflect changes The important thing to remember is that ETFs gener-
in market sentiment, while NAV may take longer to ally trade close to their fair value, and premiums or dis-
adjust—resulting in premiums and discounts. counts tend to be short-lived. However, that’s not always
the case, so dig deeper before snapping up a fund simply
WHY? because it’s trading at a discount (you may have to sell
This can happen throughout the trading day, because the at a bigger discount). Lastly, use limit orders set close to
ETF and its underlying securities are actually two distinct NAV to prevent buying at a large premium or selling at a
liquidity pools that are only loosely linked. large discount.
If optimistic investors start aggressively bidding up an
ETF—more so than its underlying securities—the price of
the ETF may rise faster than the price of its underlying secu-
Understanding
rities and, consequently, may trade at a premium.
Similarly, if pessimistic investors aggressively sell an
ETF—more so than its underlying securities—the ETF may
trade at a discount. (Imagine a sumo wrestler escaping
through a small window.)
Premiums &
Alternatively, premiums or discounts may arise because
the ETF and its underlying securities trade on exchanges
that are in different time zones.
Consider the scenario of ETFs listed on the NYSE that
track European indexes. It’s not uncommon for those ETFs
Discounts
to trade significant volume after, say, the London Stock
Exchange closes at 11:30 a.m. ET. The price of these ETFs will
reflect real-time changes in market sentiment, while NAV
will be based on stale prices from the earlier LSE close.
In this case, any significant deviation between ETF price
and NAV will likely vanish when both exchanges are open at
the same time.
HOW ARE PREMIUMS & DISCOUNTS CORRECTED?
Thanks to the creation/redemption mechanism, deviations
between ETF price and its NAV tend to be short-lived.
That said, not all premiums and discounts quickly self-
correct; some persist for a variety of reasons. For an autho-
rized participant (AP) to create or redeem shares quickly, he
or she needs access to the underlying securities—which is
JANUARY 2020 21ETF UNIVERSITY
instances where the process wasn’t smooth, but generally
it’s better to have a liquidation rather than a delisting.
When an ETF delists without liquidating its portfolio,
investors who fail to sell their shares before the last trading
date will be forced to trade over the counter—a significantly
less liquid, more cumbersome and generally more expensive
Managing
process than trading on an exchange.
DOWNSIDE OF CLOSURES
Even if a closure goes smoothly, it can still be hugely inconve-
nient, for a few reasons.
& Avoiding
From the perspective of advisors, avoiding funds at high
risk of closure can help avoid egg-on-your-face phone calls to
clients after recommending a fund that’s now closing.
Further, when an ETF delists or liquidates, it creates rein-
vestment risk for its investors—not to mention the extra and
unnecessary burden associated with reinvesting. Once you
ETF Closures
receive your cash-equivalent NAV, you’ve got to find some-
where else to put it, which could mean repeating the entire
process that landed you in the ETF to begin with.
Finally, since investors must either sell their shares or
receive cash equivalents of NAV, they’re forced to realize any
capital gains. That can mean an unanticipated tax burden.
L
ike any business, even low-cost ETFs need CLOSURE RISK FACTORS
to generate revenue to cover their costs. It’s relatively easy to predict likely candidates for closing, and
However, plenty of ETFs fail to garner the a little homework can be good insurance.
assets necessary to cover these costs and, Low AUM is one of the best indicators of closure risk. After
consequently, ETF closures happen regularly. In all, funds with hundreds of millions of dollars in assets under
fact, a significant percentage of ETFs are currently management are too profitable to close. So, $50 million is
at risk of closure. generally the threshold after which a fund is unlikely to close.
There’s no need to panic though: Broadly That said, there are hundreds of ETFs with low AUM that don’t
speaking, ETF investors don’t lose their investment close each year—and some of them are great products.
when an ETF closes, but the situation can be Surprisingly, even more important than AUM in predicting
inconvenient and costly. fund closure is the strength of its issuer. After all, when the
issuing company is unprofitable, all of its businesses are at risk.
WHAT HAPPENS WHEN AN ETF CLOSES? Consequently, when evaluating whether a low-AUM fund
Once the decision to delist or liquidate an ETF has been is at risk of closure, consider the strength of its issuer as well
made, a prospectus supplement will state the ETF’s last trad- as the issuer’s history.
ing date and its liquidation date (if it has one). Finally, if a particular ETF is the least popular (by AUM)
At this point, or soon after, “business as usual” ceases, among 10 ETFs that offer similar exposure, it’s more likely to
and the fund halts creations as it prepares to convert to cash. close than a similarly unpopular ETF that is the only ETF offer-
This causes ETF performance to diverge from the perfor- ing exposure to a particular sector/country/strategy. Essen-
mance of its underlying index. tially, unpopular funds in oversaturated markets are at greater
It’s generally advisable to sell any remaining shares you closure risk than unpopular funds offering unique exposure.
may be holding before the last day of trading.
IN SUM
DELISTING VS. LIQUIDATION Ultimately, don’t let media headlines about ETF closures
When an ETF liquidates, investors generally receive cash invoke fear, because first and foremost, ETF investors usually
distributions equal to NAV, so even if you fall asleep at the don’t stand to lose when an ETF closes. Secondly, funds at
wheel, you will receive the fair value of your shares—most risk of closure are largely easy to identify, which is to say that
of the time. It’s worth noting that there have been rare it should be easy for you to avoid the high-risk funds.
22 ETF.com/ETF Report
22ETF UNIVERSITY
S
ecurities lending is a fairly simple process that none of their underlying holdings paid dividends. In these
can generate extra returns for ETF investors, but cases, the ETF generated sufficient revenues from securities
it also introduces extra risk—however minimal. lending alone to enable a hefty dividend for its investors.
The logic behind securities lending is this: An Let’s keep things in perspective though; most ETFs
equity ETF will typically hold thousands of shares of don’t earn such lofty premiums for lending their securities.
various stocks. If there’s a short-seller out there who While they certainly provide a tail wind for ETFs, the effect
wants to borrow those stocks—and agrees to post of securities-lending revenue is usually relatively muted and
collateral and pay the ETF a fee for doing so—why not generally serves to offset expenses rather than generate sig-
lend them out and make a little extra dough? nificant outperformance.
Generally speaking, securities-lending activities It’s worth noting that, rather than distributing securities-
are positives for shareholders and contribute to tighter lending revenue as dividends, the usual course of business is
index tracking and better overall returns. They’re not for ETFs to invest the extra revenue in its portfolio holdings.
without some risks; while we believe they’re generally In this case, investors reap the rewards via fund performance
minor, they’re nonetheless worth considering. rather than dividend payments.
The takeaway is that securities lending introduces some
RISKS OF SECURITIES LENDING risk to ETF portfolios—much of which has been mitigated by
You’d think the biggest risk in securities lending is that the issuer policies. Meanwhile, the benefits of securities lending
short-seller you lent shares to goes bankrupt. Fortunately, range from negligible to highly significant.
industry practice is for borrowers to provide collateral
exceeding the value of the loaned securities by a set margin.
Understanding
So while a busted counterparty is a pain, it’s not immedi-
ately costly.
The costs come in if the borrower is a short-seller (it
usually is) and the security that they shorted rallies strongly
in a single day, the borrower defaults and the provided col-
Securities
lateral is insufficient to cover the cost of reacquiring the
security. Remember, collateral balances are only settled (at
best) daily.
EVEN THAT’S SMALL-FRY
Lending
The real risk with securities lending is that when ETF issu-
ers receive cash collateral, they don’t just sit on it—they
put it into money market securities to earn some small
amount of interest on the cash. Where firms get into trou-
ble is when these collateral investments go bankrupt, such
as when Lehman Brothers went under. It’s unlikely, but it’s
happened.
HOW PROFITABLE IS SECURITIES LENDING?
It depends. Just as prices in the rest of the economy are sub-
ject to the forces of supply and demand, so too are securi-
ties-lending premiums.
Securities that are in high demand in the loan mar-
ket command higher premiums. ETFs that hold these in-
demand securities can earn a significant premium lending
out portfolio holdings. Premiums tend to fluctuate as certain
sectors, markets or countries fall in and out of favor with
short-sellers.
When these factors align perfectly, ETFs can earn huge
premiums for lending securities. Historically, some ETFs
(those in solar in 2017, for instance) have paid dividends
amounting to a yield as high as 5-7%, despite the fact that
JANUARY 2020 23ETF UNIVERSITY
But if you wanted to buy MSFT right now, you’d probably
have to pay $50.10. If you wanted to sell right now, all you’d
get is $49.90. Those are the prices you’d get if you enter a
market order into your brokerage window.
The wider the spread, the more it will cost you to trade MSFT.
Bid/ask spreads are so important to ETP trading because,
unlike a mutual fund—which you buy and sell at net asset
Understanding
value—all ETFs trade like single stocks, so ETFs trade with
bid/ask spreads. That’s the price of the “exchange-traded”
in the name.
Spreads widen and narrow for various reasons. If the
ETF is popular and trades with robust volume, then bid/ask
Spreads
spreads tend to be narrower. But if the ETF is thinly traded, or
if the underlying securities of the fund are highly illiquid, that
can also lead to wider spreads.
Overall, the narrower the bid/ask spread, the lower the
cost to trade.
& Volume
VOLUME & MARKET IMPACT
However, when trading stocks or ETFs, you also have to look
at volume and so-called market impact.
Volume is the number of shares that trade on any given day.
The higher the volume, the better. For example, if MSFT trades,
on average, 10 million shares per day, it’ll be easier to trade than
something that trades 100 shares per day. Note, however, that
E
TFs trade like stocks. ETFs trade nothing at all spreads could be tight on both, which could mislead unwitting
like stocks. Both of these statements are true. investors to conclude that both securities are equally liquid.
But to trade ETFs, you should know why this Typically, the number of shares offered on the “bid” or
is so. the “ask” will be small—sometimes 100 shares, sometimes
more, but rarely a huge amount. If you try to buy 10,000
BID/ASK SPREAD shares of something that only trades 100 shares per day, you
The place to start with understanding how ETFs trade is to could have trouble.
understand how individual stocks trade. To go back to our MSFT example, someone might be
At any given time, there are two prices for any com- willing to sell you 100 shares of MSFT at $50.10, but if you
mon stock: the price at which someone is willing to buy that want to buy 10,000 shares, you might have to pay $50.25 or
stock (the “bid”) and the price at which someone is willing more. The amount that you drive up the price of something
to sell (the “ask”). The difference between these two prices you’re trying to buy is called the “market impact.”
is called the “spread.”
The reason spreads exist is because, in any open market, HOW DOES THAT IMPACT ETF TRADING
folks try to negotiate the best prices they can get. If you’re & HOW ARE ETFs DIFFERENT?
looking to buy, you’ll naturally want to see if someone is will- Because ETFs trade on exchanges like stocks, they have bid/
ing to sell for less than the last traded price. ask spreads, volumes and potential market impact, too. All
Conversely, if you’re selling, you’ll naturally hope that else equal, you’ll do better trading something that has high
someone will be willing to buy it for more than the last volume and a tight bid/ask spread. In this way, trading ETFs
quoted price. Spreads are simply the result of buyers and is just like trading a stock.
sellers negotiating on prices. But ETFs have a critical difference that dramatically
For example, let’s imagine Microsoft’s stock is trading alters the playing field for investors.
with the bid at $49.90 and the offer at $50.10. The spread With single stocks, there’s no way to create new shares.
is therefore $0.20. If someone asked you what a share of But institutional investors called authorized participants
MSFT was “worth,” you’d probably choose the midpoint: (APs) are allowed to create new shares of an ETF to meet
$50.00, or maybe the last price at which you can see a trade demand. So if you want to buy a lot of an ETF … say, 50,000
actually happened. shares … an AP might create those shares to fill your order.
24 ETF.com/ETF Report
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