Exchange-traded funds (ETFs) offer the best of both worlds — the benefits of diversification and money management like a mutual fund, plus the liquidity and tick-by-tick real-time trading like a stock. Other benefits include lower transaction charges for ETF trading, tax-efficient structures, and a variety of sectors/asset classes/focused investment schemes suitable to the needs of both traders and investors.
Thanks to these features, ETFs have become hugely popular in the last decade. With each passing month, new ETF offerings get introduced into the market. However, not all available ETFs fit the short-term trading criteria of high liquidity, cost efficiency, and price transparency.
According to a 2018 Investment Company Institute report, the U.S. ETF market — with 1,832 funds and $3.4 trillion in total net assets at year-end 2017—remained the largest in the world, accounting for 72 percent of the $4.7 trillion in ETF total net assets worldwide.
We will look at the main characteristics that a trader or analyst should consider before selecting an ETF for short- to mid-term trading.
- Liquidity (on and off the exchange): Liquidity is the ease of buying and selling a particular asset. The more the trading volumes are consistently visible across multiple time slots, the better the liquidity. Exchange-based volume figures are often available through an exchange’s website. However, ETF units also trade off-exchange and such off-exchange trades are reported to the Trade Reporting Facility (TRF). An example of such off-exchange bulk trade is when a gold-based fund wants to buy gold ETF units. The more ETF trading happens off-exchange, the less favorable it is for common traders, as it leads to a lack of liquidity on the exchange. Traders should keep a close eye for the TRF reports and avoid ETFs that have a high percentage of off-exchange trades.
- Indicative NAV (iNAV): ETFs have a portfolio of underlying securities. The indicative net asset value (iNAV) is the real-time valuation of the underlying basket, which acts as a “pricing guidance” for ETF indicative prices. The real ETF prices may trade at a premium/discount to the iNAV. The iNAV may be disseminated at varying intervals—every 15 seconds (for ETFs on highly-liquid assets like equities) to a few hours (for ETFs on illiquid assets like bonds). Traders should look for ETFs with high-frequency iNAV publishing, as well as a premium/discount price compared to the iNAV. The lower the difference between the iNAV and ETF unit price, the better price transparency is indicated by the ETF for its underlying assets.
An ETF has authorized participants (AP) who buy/sell underlying securities based on the demand/supply of ETF units. If demand is high, an AP will buy the underlying securities and deliver to the ETF provider (fund house). In return, he gets the equivalent ETF units in large aggregated “block sizes,” which he can sell in the market to fulfill the anticipated ETF demand. There are many APs for a particular ETF, and their activities keep the prices in check. This methodology of ETF trading is useful in understanding the following characteristics for selecting ETFs:
- Transaction Charges: ETF trading is available at comparatively lower costs than equity or derivatives trading (or even than associated mutual fund charges). This is because transaction costs are borne by the APs, instead of the ETF providing firm. However, not all ETFs have low charges. Depending on the underlying asset, ETF transaction costs may vary. For example, futures-based ETFs might have higher charges than index-based ETFs. Traders who want to frequently buy and sell ETFs for short-term trading should be vigilant about the transaction charges, as these will impact their profits.
- Unit Creation Mechanism: The block sizes to create ETF units may play an important role in pricing. While most ETFs go with a standard block size of 50,000 units, a few also have higher sizes like 100,000. The best prices are guaranteed for a standard block size, while prices may not be that favorable for “odd lot” like 15,000 units. Depending upon the available block sizes for creation units, “lower is better” from a trading perspective as there is more liquidity with small sized standard lots. Combined with daily liquidity numbers (indicating how frequently the units are getting created/redeemed), the ETF with smaller creation unit block sizes will fit the trader’s requirements better than those with large size.
- Liquidity of underlying instruments: The liquidity of an ETF is directly correlated with the liquidity of the underlying instrument(s). An ETF like SPY (SPDR ETF) on the S&P 500 Index can have high trading volume with high liquidity and price transparency because even the smallest component of the S&P 500 has very high liquidity. It allows APs to quickly create/destroy ETF units. The same may not be true for a bond-based ETF, where the underlying is an illiquid bond or even an equity-based ETF with a limited number of underlying stocks (like SPDR MFS Systematic Core Equity ETF [SYE] that has only 51 holdings). Traders should carefully study and opt for the ETFs that have high liquidity for the underlying instruments, along with the ETFs' own liquidity.
- Daily fund inflow/outflow: The end-of-the-day report for daily fund inflow/outflow indicates the net amount of capital that was invested in/taken out from an ETF. This report gives a sense of market sentiment for that particular fund, which may be used, along with other mentioned factors, to assess an ETF for short- or mid-term trading strategies like momentum or trend reversal-based trading.
The Bottom Line
Not all available securities and asset classes suit short- or mid-term trading, and the same applies to ETFs. With the continuous introduction of new ETFs in the market, it is often confusing for a trader to select the ETF that gives them the best fit for their trading strategy. While the above-mentioned pointers can help a trader to avoid ignorant pitfalls for ETF trading, traders are advised to familiarize themselves thoroughly with any ETFs of interest and assess them fully to see which fit their selected trade strategy.