FEBRUARY 1, 2010
The world of exchange-traded funds
looks like an ocean of liquidity: billions of shares trading all day long on
easily accessible exchanges.
See the complete Investing in Funds: A Monthly Analysis report.
Note: ETF data tables will be available
Monday, Feb. 1.
But beneath the surface is a
treacherous landscape of potential trading problems that can raise costs for
individual investors.
The ease of buying and selling ETFs,
which typically resemble index-tracking mutual funds but trade like stocks, has
helped make them the darlings of investors big and small. But as ETFs delve
into more esoteric areas of the market such as high-yield bonds and commodity
futures, trading them has become more complex.
Also contributing to problems with
liquidity—or the ease with which these products can be bought and sold without
big trading costs—are things like regulatory scrutiny, strong investor demand
for certain ETFs and the fact that many of these funds now launch with the bare
minimum level of assets—often just $2.5 million or so.
There are "a lot of dissatisfied
customers" discovering snags in ETF trading, says Scott Burns, director of
ETF research at Morningstar Inc.
A lack of liquidity can lead to wide
"bid-ask spreads," or the gap between the price buyers are willing to
pay for shares of an ETF and the price sellers are asking. The wider the
spread, the bigger the bite taken out of investors' returns every time they buy
or sell. A lack of liquidity also may cause the ETF to trade at a large premium
or discount to net asset value, or NAV—the value of the fund's underlying
holdings. That means an investor buying the fund may overpay for that
portfolio, or an investor selling could get less than that basket of securities
is worth.
These issues haven't stopped investors
from flocking to ETFs, however. Assets in U.S.-listed exchange-traded products
totaled $791 billion at the end of December, a 47% jump from a year earlier.
ETF trading volume, meanwhile, averaged 1.9 billion shares a day in 2009, up
20% from a year earlier, according to the National Stock Exchange.
To size up an ETF's liquidity,
investors need to examine the fund's underlying holdings as well as the ETF
shares themselves. Here's a look at the major points to consider before buying
or selling an ETF, as well as some tips on trading these funds smoothly and
cheaply.
A glance at an individual ETF's trading
volume or bid-ask spread doesn't tell the whole liquidity story, but it offers
key information for investors.
ETF assets and trading volume are highly
concentrated in just a handful of funds. The 10 largest ETFs account for almost
40% of total ETF assets, while the 10 funds with the largest dollar trading
volume accounted for roughly 60% of the total volume for all ETFs in December,
according to National Stock Exchange.
Investors trying to buy or sell these
ultrapopular ETFs probably won't run into problems. Consider the SPDR, which tracks the Standard & Poor's
500-stock index. Almost 3 billion SPDR shares changed hands in December,
according to NYSE Arca, with an average bid-ask spread of just a penny.
At the opposite end of the spectrum is
the Claymore U.S. Capital Markets Bond ETF. Fewer
than 12,000 shares traded in December, and the average spread was a whopping
$2.56.
One problem is that market makers—those
who help maintain orderly trading in ETFs—get rebates from exchanges that are
calculated on a per-share basis. Thus, they may not have much incentive to
maintain relatively narrow gaps between bid and ask prices in funds with very
low trading volume.
"We're not happy" with how
the Claymore U.S. Capital Markets Bond ETF is trading, says Bill Belden,
managing director at Claymore Securities Inc. In discussions with the exchange
and market makers, he says, "we continue to push for more efficient
pricing" in the fund.
Spreads of more than five to 10 cents
"would concern me," says Matt Hougan, editor of IndexUniverse.com.
"If it's 50 cents, I would run screaming." More than 300 of the
roughly 800 ETFs trading on NYSE Arca in December had average spreads of more
than five cents, while six had spreads of more than 50 cents.
Other problems can arise when an ETF
has to suspend issuing new shares. Specifically, big gaps can develop between
the ETF share price and the value of its underlying holdings.
In some cases, regulatory scrutiny
sparks the problem. In late August, for example, BlackRock Inc.'s iShares unit
announced that it had suspended creation of new shares of its iShares S&P GSCI Commodity-Indexed Trust
ETF amid concern that the Commodity Futures Trading Commission might limit the
size of firms' positions in various commodity futures. The fund began trading
at a significant distance from its NAV, including a roughly 4% premium on Oct.
1, though the gap has narrowed recently.
Sometimes ETFs offer only a limited
number of shares and require regulatory approval to issue more. In such cases,
investor demand can outstrip this supply. That's what happened to PowerShares DB US Dollar Index Bullish fund,
which had to suspend creation of new shares in December for the second time in
two months because of voracious investor appetite for the product. It resumed
issuing shares on Jan. 5.
While it's important to look at how ETF
shares are trading, the fund's underlying holdings are really the heart of the
liquidity issue, experts say.
One reason: Big investors known as
"authorized participants" can swap a basket of the fund's underlying
holdings for ETF shares—or vice versa. This process helps arbitrage away
significant gaps between the ETF's share price and its NAV, the value of its
underlying holdings. But when the underlying holdings are costly to trade and
tough to obtain, authorized participants are less willing to round up that
basket of securities. That means big gaps can develop between an ETF's share
price and its NAV.
One place to watch out for these
premiums and discounts is in bond ETFs, especially those focused on areas like
corporate investment-grade and high-yield, or "junk," bonds. The
closed within 0.5% of NAV on only four days in the fourth quarter, iShares
says, and traded at a premium as large as 2.1% in that period.
The premium is "a reflection of
the cost to trade the underlying bond portfolio," says Leland Clemons,
director of the iShares capital-markets group. Investors should expect to
regularly see 1% to 2% premiums in the high-yield ETF, he says, and possibly 4%
in times of greater volatility.
When underlying holdings are traded
less frequently, or not at all, an ETF's returns also may diverge from the
benchmark it is designed to track. That became an issue for some bond ETFs
recently as the Federal Reserve bought up large quantities of agency bonds and
mortgage-backed securities, essentially removing them from the market. Vanguard
Group recently changed some of its bond index funds and ETFs to benchmarks that
exclude these securities purchased by the Fed.
The biggest test of bond-ETF liquidity
may be yet to come. So far investors have poured money into these products, and
many bond ETFs are trading at significant premiums to NAV. But if investors
reverse course and stampede out, the trading could get ugly, experts say. Given
the relative illiquidity of many of the underlying bonds, the ETFs could start
trading at significant discounts to NAV.
"When everybody tries to get out,
it's going to be a debacle," says Scott Freeze, president of Street One
Financial.
Experts say one simple rule can go a
long way toward alleviating ETF trading problems: Use a "limit"
order. This means your trade will be executed only within the price range you
specify, not at whatever price the market gives you.
To help determine the price you should
be paying, check out the ETF's "indicative" net asset value, which
gives an up-to-the-minute look at the value of the fund's holdings. The iNAV
for each ETF is calculated every 15 seconds and is available on sites like
Yahoo! Finance or Google Finance. Andrew McOrmond, a managing director at
institutional execution-and-trading firm WallachBeth Capital LLC, suggests
setting your "limit" slightly above iNAV when buying an ETF and
slightly below iNAV when selling it.
One caveat: The iNAV isn't a useful
gauge for international ETFs whose markets are closed while you're trading.
If you're looking to do a large trade
in a relatively illiquid ETF, consider asking for help, experts say. If your
trade will amount to more than 10% of the ETF's average daily volume, call the
ETF provider or your brokerage firm and ask for assistance, Morningstar's Mr.
Burns says.
Investors might also want to avoid
trading ETFs at the very beginning or end of the trading day, experts say, when
the market can be more volatile.
Finally, with new ETFs constantly
hitting the market, investors might not want to dive in as soon as a fund
starts trading. "Watch it trade and give it some time to work out the
kinks" if you're concerned about liquidity problems, IndexUniverse's Mr.
Hougan says. "Don't buy it on day one."
—Ms. Laise is a reporter for The Wall Street Journal in
New York. Email: [email protected]