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Chances are you’re an advisors that deploys exchange traded funds within client portfolios. The extent to which an advisor does so isn’t linear, but with nearly 3,300 US-listed exchange traded products (ETPs) with $8.4 trillion in combined assets under management, according to ETFGI, as of the end of February, it’s clear advisors are among the primary drivers of ETF adoption.
Likewise, many clients already own ETFs in their discretionary accounts, through retirement accounts and perhaps through employer-sponsored retirement plans. Various data points and studies confirm that the younger clients are, the more likely they are to own at least one ETF with plans to add more.
Advisors looking to hone on which client demographics have the largest percentage of ETF ownership outside the accounts the advisor manages on their behalves might want to start with Gen X and work their way down.
Conversely, many baby boomers and those in the so-called silent generation are apt to have fewer ETFs in their accounts. Some of that is attributable to those generations being groomed on mutual funds and some of it has to do with some older investors erroneously viewing ETFs as complex. As advisors know, that’s not the case and that thinking can force investors to miss out on some of the advantages associated with ETFs.
Answering Important ETF Questions
Many clients that are accustomed to index funds and mutual funds know that those products trade at one price per day – the net asset value of the fund. Conversely, ETFs trade like stocks and that’s derived from ETFs’ ties to the primary market – a trait not found with index and mutual funds.
“The ETF creation and redemption processes take place in the primary market. A creation or redemption takes place between the ETF issuer and the authorized participant (“AP”). These transactions occur away from an exchange and are not accessible to regular investors,” notes Vanya Sharma, senior capital markets associate at WisdomTree. “An AP is a financial institution that offers basket liquidity in the primary market, which is different from a market maker’s role as a liquidity provider in the secondary market. In times when an ETF market price is not trading close to its intrinsic value, the AP also hopes to profit from an ETF via arbitrage when the ETF share price is different from the underlying basket’s value.”
Another question ETF newbies often have about these products is whether the on screen volume they see is the most accurate gauge of the fund’s liquidity. That’s an astute question to ask because some ETFs aren’t heavily traded, implying they lack robust liquidity, when in reality that’s not the case.
“The ‘true’ liquidity of an ETF is based on its underlying assets and is as liquid as its least liquid underlying security in the basket. Hence, by themselves, the ETF’s average trading volume and total assets do not paint the full liquidity picture,” adds Sharma.
Exploring Total ETF Costs
Another issue advisors should raise with ETF rookies is that there are costs associated with these products beyond the annual expense ratio. Fortunately, broadly speaking, ETFs best mutual funds on the total cost of ownership, particularly when the ETF in question is able to sport tight bid/ask spreads and remain close to or at its net asset without drifting too far in either direction.
The bid/ask spread on an ETF is important because it can give an investor a clear total cost of ownership picture.
“Simply, it incorporates all the trading costs (create/redeem fees, spreads of underlying securities in the basket, hedging costs, trade financing costs and taxes) and gets passed on to the investor. Numerically, the investor should view the spread as a fraction of the ETF price,” concludes Sharma. “For example, an ETF with a spread of 20 cents and a share price of $50 will be considered to be more expensive (0.20/50 = 0.40% or 40 bps) than one with a share price of $100 (0.2/100 = 0.20% or 20 bps).”
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