What You Need to Know Before Buying ETFs (Part 2)

Looking at trading costs and price dislocation.

Christine Benz 15.04.2016
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In part 1 of this interview, Joel talked about the general ideas of cost for ETFs. In part 2 of this interview, Joel will explore the aspect of trading costs and price dislocations.

Benz: That's a helpful rule of thumb. One other topic I want to cover with you is this idea that traditional mutual funds have trading costs, too, that are not reflected in their expense ratios, whereas if you're buying and selling ETFs, you are bearing some of those trading costs yourself. Let's talk about how investors can think about and potentially unpack that question. 

Dickson: That's a very important distinction because this often shows up in periods where you'll see changes in liquidity in the underlying securities of an ETF and a mutual fund. So, there's the idea that the net asset value of the fund reflects the current value of the securities--and net asset value is computed for ETFs, computed for funds, and so forth. The market price, or the transaction price, of the ETF on the exchange can actually differ from the net asset value, or the value of the underlying assets for any number of reasons, but the major reason is that the ETF investor is bearing the full extent of their transaction costs.

So, if I buy ETF shares and somebody else on the exchange has sold them to me, there's actually no portfolio impact on that. So, if I sold a share of VTI and somebody else bought a share of VTI from me, the portfolio of our total stock market fund is actually not affected because there was no transaction at the fund level. But there are transaction costs from market makers or from the ability to acquire the underlying securities of the basket and what those costs look like, and there are times when those will vary. And because of that, the difference between the market price of the ETF and the net asset value--or the value of the underlying securities--can vary based on changing cost parameters. We see this in the fixed-income space occasionally, where there might be liquidity concerns about fixed-income instruments. And what that means is that the price for liquidity has increased.

So, if you're trying to sell when everyone else is trying to sell, to get somebody to buy that, you're going to have to pay a liquidity premium. That means probably paying a discount to the fund's current net asset value to get somebody to come in and be able to take that liquidity. So, in the traditional fund, if a bunch of shareholders from a mutual fund are selling, the portfolio manager is now selling those fixed-income instruments. And while they will also--if it's more costly to sell--realize that additional cost in selling, it's going to show up in the net asset value, not in the difference between, say, the transaction (because there's no portfolio impact) and the net asset value, as it would with the ETF. The summary is if you are transacting as an ETF investor, you're responsible for the transaction costs that would be incurred on your investment. In a traditional mutual fund, often those transaction costs are spread over the other investors in the fund.

Benz: It's an important--albeit complicated--issue, but I think it's worth taking a look at. I just have one last question for you, Joel. We've seen these periodic market dislocations where we've seen some ETFs trade way out of line, so their market price is way different from their net asset values. How can investors protect themselves in this kind of environment? I'm sure you'd say, "Well, don't be transacting if you can possibly avoid it during such times." But what other steps can ETF investors take to make sure that they don't inadvertently get caught up in one of these bad price dislocations.

Dickson: Because there is this opportunity that the market price may be different from the value of the underlying securities, I think the first thing is to get out of this assumption that I think we all implicitly have that the ETF will always trade right on top of the value of the underlying securities. Yes, there are a lot of mechanisms to try to ensure that happens in as many instances as possible. You hear about the arbitrage mechanism of ETFs--and yes, that should keep things relatively in line. But there are periods--whether it might be different market events or how the underlying securities themselves trade--where you can have some dislocations.

We certainly saw this on Aug. 24 of this year. There was a lot of volatility in the market. We had these relatively new procedures called "limit up, limit down" that affect how much a security can move and whether a security gets halted. This was sort of the first real live test in a volatile market environment since those rules had been put in place. And while they worked as written, it looks like there could be some improvements on how especially ETFs, but even individual securities, work in relation to those types of rules. So, you did see a couple of what might be viewed as strange prints. There are ways, however, as market-structure rules continue to evolve to make sure that that hopefully doesn't happen as much in the future. But regardless, we don't know what the next event will be that might cause a little bit of dislocation.

So, there are things investors can do to protect themselves--and in particular, especially with exchange traded funds. Using limit orders can be a really good protection for investors, because there's really not a lot of debate about what the price of the ETF should be if you know what the price of the underlying security should be. It's an accumulation of those underlying securities--and relative to some transaction costs around that, it should be probably fairly close. And by having a limit order, you can tie that better to the value of the underlying securities and protect yourself from those situations that happen. The other thing is--especially if you aren't using a limit order--when trading at the beginning of the trading day or at the end of the trading day, there can be a little bit more volatility in exchange-traded-fund prices. It's important to understand the trading environment, as well as the underlying investments, if you are in ETFs.

So, the two major things: Use limit orders, if at all possible, and be careful about what time you are trading. And then related to using limit orders, stop orders can be very problematic with ETFs; this is kind of what seems to have occurred on Aug. 24. If you get this downdraft and you've put in a stop order on a particular price to protect you on the downside, stop orders immediately turn into market orders. And if you have an environment like on Aug. 24 where there were a lot of imbalances between sells and buys, that market order that just got triggered may actually push the ETF price down even more--not necessarily help it return to where you might expect it to be relative to its underlying holdings.

So, stop orders can be really problematic, and I think a lot of investors don't necessarily always understand that they immediately turn into market orders once they get triggered. You could actually end up with a fairly poor execution in those situations.

Benz: Joel, some valuable pieces of advice. Thank you so much for being here to share them with us.

Dickson: Thanks a lot, Christine.



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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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