More than 800 exchange-traded funds are traded daily — and that is just in the United States. So, how can an advisor know which one to choose?
Two of the top minds in the ETF industry revealed nine things that most advisors need to know about these products in order to execute these trades successfully.
1. Look at the underlying liquidity—not just assets.
Look for ETFs with at least $50 million in assets. Here, it’s the more, the better, according to Tom Lydon, president of Global Trends and ETF Trends. He said that assets are an indicator of overall liquidity.
But they are not the only indicator, according to John Gabriel, an ETF analyst at Morningstar [MORN]. One mistake that advisors often make in trying to gauge liquidity in ETFs is that they look at the same measures as they would for stocks — this, he said, is a mistake.
“With stocks, assets and trading volume are key indicators of liquidity because you have a fixed number of shares," Gabriel said. "But with ETFs the creation and redemption process means shares can be created or redeemed on an ongoing basis, so the underlying liquidity is more important than the assets themselves."
2. Find out what percentage of the ETF’s daily trading volume your trade would be.
Another good thing to look at is the volume of the ETF — the more volume it has, the better, Lydon said.
While there’s no magic number for volume, the higher it is, the less likely it is that your trade will move the fund. To keep track of this, Gabriel recommended looking at the size of the trade and figuring out what percentage of the daily trading volume of that ETF it is. To determine this, look up the average trading volume for the past three months, and divide the dollar amount of the trade you want to execute into it. If you’re 10% of the daily trading value or less, that can be considered a safe zone, Gabriel said.
3. Be aware of the bid/ask spread.
The bid/ask spread is one of the most overlooked components of the overall cost of trading, Gabriel said. Wide bid/ask spreads are typically seen in thinly traded funds, Lydon said, who insists that an acceptable average spread on an ETF is five or ten cents per share.
When trading funds with a wide spread, he suggested using limit orders to control your costs. These put the pricing control in your hands—when you set one, you’re stating the maximum amount you want to pay, thus eliminating expensive surprises.
4. The fund’s holdings are as important as its fund family.
It’s not only wise to know the names of the ETF's you own, but Lydon suggested also knowing how those names are weighted.
Some funds have heavy weightings in just a few names; others are equally weighted across dozens. This will affect your fund’s performance, he said. Gabriel recommended sticking with a single fund family as much as possible within one client’s portfolio, since blending or mixing index fund families opens the door to overlaps or gaps in the portfolio.
5. Use an alternate liquidity specialist for large client trades.
When placing a large trade for clients, (especially in a low-volume fund), some suggest working it in small batches to avoid moving the price too much. However, if advisors don’t have access to commission-free platforms, this could mean a build-up in transaction costs.
To avoid such expenses, advisors can use an alternate liquidity specialist. These specialists, who are widely unheard of by most advisors, can aggregate orders from different advisors who have similar trade requests. They can then aggregate the creation basket and distribute the trades collectively so they don’t blow out the bid/ask spread, Gabriel said.
6. Consider the overall cost of the fund.
ETFs have long been touted as low-cost vehicles, with expense ratios far below that of comparable mutual funds. But while expenses may seem small — 0.25% here, 0.5% there — Lydon said that over decades of investing, these costs add up and will eat into returns.
Even further, not all ETFs are created equally. With the proliferation of more exotic and niche products in the market these days, many of the newer funds are more expensive, Gabriel said.
Expense ratios become more and more important for advisors working with a long-term horizon, he said, as these costs compound. Expense ratios are more important than ever, as this booming market becomes increasingly competitive. Gabriel said that advisors need to look at the overall cost of the fund.
“You can be lured in by free commissions, like those introduced by Fidelity and Schwab [SCHW], but if you buy an ETF with a significantly higher expense ratio, you still end up a loser in the long run," he said.
7. Look beyond the name.
Many “global” or “international” funds have heavy weightings toward the United States, Lydon said. Many infrastructure funds are heavy in utilities. Not all currency funds hold actual currencies. The key is to match your investment thesis with the vehicle, Gabriel said.
8. Manage client’s expectations of leveraged and inverse ETFs.
Leveraged and inverse-leveraged ETFs have been in the news ever since their popularity skyrocketed during the recent downturn. These funds are short-term trading vehicles, which compound daily.
While some advisors recommend not using them at all in a long-term portfolio, these funds do exactly what they say they will — as long as they are very actively traded, by sophisticated investors. In order to use them in client portfolios, Gabriel said that he strongly urges adjusting investor expectations and ensuring the client understands the daily compounding and the suggested one- to two-day holding period.
9. Not all ETFs are tax-efficient.
When the first ETFs hit the market more than 10 years ago, they were marketed as tax-efficient vehicles. But times have changed. As more exotic products come to market, especially futures-based funds (such as leveraged ETFs) and commodity ETFs, tax efficiency has become a little foggier.
“These are totally different animals in terms of taxation,” Gabriel said. “They are taxed every year on at least 60% long-term and 40% short-term capital gains. ETFs are a look-through vehicle, so the IRS is looking to the underlying assets. You’ll have to recognize those gains every year even if you don’t sell.”
Taxation is also a bit different with commodity-based ETFs. These are structured as limited partnerships, which means investors who own these funds during tax times will receive K(1) forms, instead of 1099s.