Exchange Traded Funds (ETFs) have exploded in popularity with both retail and institutional investors since they were first introduced back in 1993. There is a lot of education available on the advantages of using ETFs and how to best allocate assets with them. There is, however, very little education available on how to effectively trade ETFs. This point was driven home during the flash crash of May 6th, with ETFs accounting for more than 60% of all canceled trades during that time period.
In the last year, ETFs have over-taken mutual funds in Assets Under Management (AUM) and new classes have emerged. Both retail and institutional use of ETFs continue to grow, and there are no signs of this slowing down. ETFs trade nothing like a single stock or mutual fund, however, some investors trade them assuming they have the same qualities. Contrary to popular belief, ETFs are not mutual funds that trade like a stock. ETFs trade in a similar fashion when compared to individual stocks with such provisions as placing limit orders, short-selling and protecting the downside with stop-loss orders – all features that are not available for mutual funds.
About a year ago, the “flash crash” of May 6th showed one glaring issue facing the Exchange-Traded Funds (ETFs) market. This issue stared directly at investors who lacked the knowledge on how to effectively trade ETFs. To properly trade an ETF, the investor must have an understanding of how an ETF is constructed, what securities comprise the underlying basket, and how these underlying securities trade.
Often times, due to this lack of this understanding, an ETF will trade at significant disparity from its NAV. If investors have an accurate read of the NAV and understand the real liquidity, they are then empowered to set an appropriate limit order and potentially trade the ETF where it should be traded. This gives investors the advantage of being an informed buyer and may protect them from buying too high, or selling too low.
To understand the fair price of an ETF, investors must know:
- The real-time Net Asset Value (NAV) of the underlying basket; and
- The Average Daily Trading Volume (ADTV) is not an accurate reflection of the actual liquidity of the ETF; and
- The ADTV in addition to each underlying securities liquidity is the true ETF liquidity.
In addition to this, investors can take advantage of the cost-savings opportunities provided by trading ETFs when compared to other investment vehicles such as mutual funds that charge redemption fees and front-end or back-end load that are not applicable in the ETFs.
Lastly, investors should find an agency ETF price and size discovery trading platform that provides the tools and information to trade ETFs at a more favorable execution price while also finding hidden liquidity, and has a number of built-in safeguards designed to prevent orders from being executed when the ETF price deviates too far from the NAV. During the flash crash, investors who had the knowledge and the tools to effectively trade ETFs were safe when executing orders on May 6th 2010.