There is more to ETFs than you think

The Financial Post has a very good article today on the ciomplexity of ETFs and the way they trade. ETFs are no doubt better than mutual funds in most ways, but they do have certain complexities that not many people know about.

The author attended a session by PowerShares which it hosted  for advisors, covering the shortcomings of traditionalmarket-cap-weighted indexes (and ETFs tracking them) versus enhanced or "fundamental" indexing like that used by ETFs based on RAFI (Research Affiliates Fundamental Index.)

"The most interesting session was a panel involving three market makers and designated brokers. The stage was set in a backgrounder by Cooke on ETF liquidity, titled More than meets the eye. Because they're openended structures, ETFs don't trade precisely like stocks. Cooke argues stocks trade in an "auction" market with a fixed number of shares available. The value of a stock is determined "by the aggregate opinion of the outright value of the company in question." Based on all combined public investor opinions derived from publicly available information, the "correct" value of the stock is its current market price.

ETFs are different: Because of the way they are created and redeemed, they trade in an arbitrage situation. Bid and ask prices aren't arrived at through supply and demand of the ETF units themselves or by ETF unit trading volume. Rather, prices are determined by the value and liquidity of the underlying baskets of securities.

Or as Cooke summarizes, "ETFs do not trade like stocks. They trade like the sum of the stocks that comprise them." Designated brokers and dealers can create and redeem units to meet investor demand. They can also create extra units by assembling a basket of the stocks held in the ETF in the same relative weights, then exchanging the units for ETF units. For ETF redemptions, this is reversed.

One implication is there is a not a fixed number of ETF units in the marketplace, so liquidity of the ETFs is tied to liquidity of underlying holdings. Second, it allows designated brokers to spot arbitrage opportunities if the ETF trades at a discount or premium to net asset value.

Investors need to pay attention to market depth on ETFs and will be better off using limit orders rather than orders "at market." Cooke says market depth offers a more complete picture by revealing where the true liquidity on an ETF can be found. Sometimes market makers will post their best bids and best offers at prices reflecting the cost of hedging their market risk. This can create a "mirage" of liquidity based on small-sized bids and offers. "Market depth helps investors see where market makers post largersize bids and offers a better indication of where most ETF trades can be executed."

The main risk with a limit order is the risk of the whole trade not going through. But this is better than buying or selling at a hefty premium or discount to the ETF's worth. John Hoffman, PowerShares' director of institutional sales, suggested investors "avoid market orders. Always use limit orders when possible. A limit order ultimately protects you on price. A market order puts the priority on speed. A limit order is not protected on speed but on price of execution."
One advantage of ETF liquidity is sellers don't necessarily have to be matched with buyers. Cooke cites a real-life example from September. An institution wanted to buy almost 600,000 units of the PowerShares 1-5 Year Laddered Investment Grade Corporate Bond Index ETF (PSB/TSX), even though the average daily volume was only 10% of that amount. If this involved a single stock or bond, such an outsized order might push the price up, but in this case, the market maker created units by acquiring the underlying basket of liquid corporate bonds. The large trade was executed as a single block with minimal price disruption. "This illustrates how effectively even a large trade can be executed in a relatively illiquid ETF, assuming there is an investable basket of securities."

At the seminar, TD Securities vice-president Alex Perel observed that "fixed-income ETFs are by far the best deal for investors because of institutional pricing."
I came away with the impression there's more to choosing and trading ETFs than investors realize - and I dare say many advisors could say the same as they make the shift to ETFs from mutual funds"