Your Popular ETF Questions Answered

Q&A for our Morningstar readers

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As analysts who deal with exchange-traded products on a daily basis, it can be all too easy to immerse ourselves in the study of very niche exchange-traded fund peculiarities. For that very reason, we often rely on you, the reader, to focus our energies. We have noticed that Morningstar readers, and website users have raised questions that span a broad range of topics--from ETF basics to macro portfolio-level allocation decisions--we've noticed several recurring themes. We at Morningstar really appreciate this user interaction and feedback and would like to take this opportunity to address your questions.

 

Can you explain the ETF market price vs. net asset value, and why there aren't the disparities you'd see in closed-end funds?

An ETF's net asset value, or NAV, is calculated by dividing a fund's total net assets by its number of shares outstanding. This is calculated at the close of trading.

While the NAV is determined by the prices of an ETF's underlying holdings, the market price of an ETF is set by the supply and demand for the ETF shares. During times when demand for an ETF exceeds supply, the price of the ETF could trade at a premium to NAV; and when supply exceeds demand, the ETF could trade at a discount to NAV. However, ETFs generally do not trade at persistent large premiums or discounts because special market makers, called authorized participants, or APs, can create and redeem shares with the fund company to arbitrage away any premium or discount. Closed-end funds do not have this creation and redemption mechanism (the number of shares of a closed-end fund is fixed), and that is why CEFs can trade at significant premiums or discounts to NAV over an extended period of time.

 

How often do indexes rebalance or reconstitute, and do ETFs have the ability to add or subtract from their index at will?

Each index has a unique set of protocols, but generally speaking, most index families rebalance quarterly or annually.

 

Most ETFs endeavor to closely follow the lead of their respective benchmarks by holding all index constituents. In some cases, however, full replication of an index may prove prohibitively inefficient. Broad corporate bond indexes, for instance, can contain thousands of underlying holdings, many of which are highly illiquid, and such illiquidity can create serious drag for a vehicle using a full replication strategy. Instead of holding all index constituents, a number of ETFs will allow employ a partial replication strategy, whereby the fund holds a representative sample of index constituents that look to provide very similar performance to the overall benchmark.

 

This drive of this question zeros in on the concern that fund managers may exercise a bit more agency than one would expect in an indexed vehicle. We can tell you that we haven't seen an ETF make a significant unwarranted deviation from the benchmark in the past, and investors shouldn't expect them to in the future.

 

Can you speak to the roll yield problem with commodity ETFs? Is this a problem across the board for all commodity-focused ETFs?

Within the ETF space, there are three ways to gain commodities exposure: equity-based funds, futures-based funds, and funds that back their shares with physical holdings of their target commodity. Roll yield will affect only futures-based funds.

 

When the price of a longer-dated futures contract is above the implied spot price of the commodity, the higher futures price will converge to the lower current price as its maturity nears. That phenomenon is known as a negative "roll yield," and such markets are said to be in a state of contango. The opposite holds true if the longer-dated futures price is lower than the current price, which results in a positive roll yield, in which case the market is said to be in backwardation. As a result, the price performance of funds that track a futures-based index can be quite different from the spot price performance of the underlying commodity.

 

Can you explain which orders would be best suited for use with ETFs?

The standout issue here is the use of "stop-loss" orders. Using stop-loss orders can be dangerous during periods of high volatility. During the flash crash, for instance, the market spiked down in a very short period of time, as a chain of stop-loss orders were triggered. While prices snapped back as quickly as they had dropped, using stop-loss orders would've locked in large losses.

 

Using "stop-limit," while better than a stop-loss, still has drawbacks. In situations such as the flash crash, a sell stop-limit order would not have executed during the rapid market decline but would have executed as the market recovered. As such, investors using this strategy would've locked in the loss they set their stop at. Unless you are actively watching the markets while they are open, we would suggest using limit orders. While the limit order is about as vanilla as it gets, you know exactly where you're going to be filled, and they go a long way toward ensuring that your position doesn't get away from you.

 

 

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure

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