Ready to Dive Into ETFs? Read This Q&A Before Taking the Leap

Written by: JPMorgan Asset Management’s Capital Markets Desk

In line with evolving client needs is the growth and evolution of investment vehicles available to advisors. ETFs have been steadily gaining in popularity ever since they were introduced more than two decades ago, bringing a few key benefits to the market place including lower prices, tax efficiencies, and liquidity advantages. It’s no wonder ETFs are projected to triple in the next five years.

Of course, that doesn’t mean ETFs are right for everyone or every situation. Before diving into these waters, it’s wise for advisors to understand the liquidity and trading mechanics of ETFs to leverage this tool as effectively as possible within your portfolios. Whether you’re new to ETFs or have never quite gotten a handle on the details, here are five basic questions—and clear, understandable answers—to help get you started:

Q: ETFs are considered more liquid than stocks, but why?

A: When trading individual stocks, liquidity is determined by trading volume in the secondary market. For ETFs, however, liquidity is based not on a single stock, but on the liquidity of all of the fund’s underlying holdings. While it’s not intuitive, that means that small or thinly traded ETFs can actually be highly liquid instruments. That’s because, unlike individual stocks that typically have a fixed supply of shares, ETFs are open-ended vehicles whose shares can be created or redeemed to meet the supply and demand needs of investors. The process is pretty straightforward:

Each ETF has what’s called a “lead market maker” who is responsible for providing liquidity on exchange by continuously buying and selling the ETF at the publicly quoted price.

When investor demand for the ETF outweighs supply, the market maker works with an authorized participant (i.e broker dealer) to create more shares by accumulating the underlying securities of the fund in the exact quantity set forth by the ETF issuer. Those securities are then transferred in-kind to the ETF issuer in return for new ETF shares. This in-kind transfer is also a tax efficient process. While most ETFs employ this process, some funds transact in cash, similar to mutual funds. This is usually typical when the fund holds certain fixed income instruments or non-in-kindable securities.

When supply outweighs demand, this process happens in reverse. ETF shares are sent to the issuer in exchange for the securities, which are then sold into the market.

This cyclical process enables ETFs to trade with much greater liquidity and at prices that closely approximate the Net Asset Value (or NAV) or the ETF.

Q: When trading ETFS, does the time of day matter?

A: Unlike mutual funds, which are traded once a day and are executed at the day’s closing NAV, ETFs are traded in real-time. Because markets tend to be more volatile near the open and close of each trading day, it’s usually wise to trade ETFs after the first 20 minutes and before the last 20 minutes of the day. There is also less liquidity in opening and closing auctions because market makers who are seeking arbitrage opportunities (often to keep ETF prices in line with their indices) do not participate in these auctions as fully as they do in the middle of the trading day.

Q: When trading ETFs, which trading order type is preferred?

A: Each time you buy or sell an ETF, you will need to select an order type. While many exist, there are three that are most commonly used by ETF investors. They are: Market Orders, Limit Orders, or Not-Held Orders. Each order type has specific pros and cons, which makes it important to choose the one that best meets your trading objectives. In general, Limit Orders or Not-Held Orders are preferable. Here’s the breakdown at a glance:

Q: How do ETFs create tax efficiencies?

A: They do so in three ways. First, many ETFs are index funds that turnover infrequently. This means they are less prone to capital gains than actively managed funds. Second, investors transact on exchange. A majority of this activity does not lead to transactions in the underlying basket, which could trigger a capital gain. Finally, most ETFs transact in-kind as noted above. This process helps the funds become more tax efficient over time as tax lots with the lowest cost basis are removed from the portfolio during “redemptions”—a non-taxable event.

Related: The Top 3 Questions on the Minds of Advisors

Q: I’m not fully comfortable trading ETFs… are there resources to guide me through the process?

A: Before placing trades, you may find it helpful to contact the ETF issuer directly. At J.P. Morgan, we have an ETF Capital Markets Desk that maintains a keen eye on the market at all times and have proprietary trading models that can assist with understanding the costs involved in execution. Our strong relationships with market makers and APs, as well as our major presence in the marketplace, help deliver the trading expertise many investors seek.

Accurate knowledge of the liquidity and trading mechanics of ETFs helps investors execute their ideas. With more than 2,000 ETFs listed on the US exchanges today, it’s more important than ever to start with a strong understanding how ETFs work and which ETFs may be the most appropriate for your needs.

To learn more call us at 1-844-CAP-MKTS or visit jpmorganetf.com. Now is the time to start putting the power of ETFs to work for you and your clients.

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