Facing a Massive Menu of ETFs? 4 Steps for Smart Choices
Written by: Jillian DelSignore, Head of ETF Distribution at J.P. Morgan Asset Management
The Cheesecake Factory opened its first New York City location back in November, and it was met with unexpected enthusiasm. Who would have thought that in a city known as the home of many of the world’s top-rated restaurants—where food is as much an art as a pastime—a monstrous chain like The Cheesecake Factory would draw three-hour-long lines? The simple answer: choice. The enormous, spiral-bound menu boasts pages and pages with enough gastronomic options to ensure that even the pickiest eaters in your party will find something to feed their cravings. And yet, facing so many choices, deciding what to order can be more than a little overwhelming.
In the world of ETFs, advisors face a similar challenge. Simply put, the menu of ETFs is massive. And while advisors used to debate only about the merits of active versus passive investing, the recent growth of the ETF market has fundamentally changed that conversation to include every strategy under the sun: active vs. passive, strategic beta vs. market cap, single factor vs. multi-factor…the list goes on. So when your goal is to add low-cost, transparent, liquid products to your portfolio—and the menu includes more than 2,000 options to choose from—where do you even begin?
As with any type of investing, it’s critical to take the time to identify your goals before you begin. What are you trying to achieve by adding an ETF to the portfolio? What exactly are you seeking to achieve with your exposures? Once that’s clear, the following four steps can help you evaluate your investment options and make the best possible choices for your portfolio.
Step 1: Choose a sponsor that shares your values—and adds value to the process.
If your goal is to select an ETF based on your clients’ needs, working with a sponsor that offers experience in investment management can go a long way toward helping you understand the “why and how” behind each choice, rather than just the mechanics of the product design. A sponsor that is also working in your clients’ best interests will be vested in helping you make optimal selections, as well as educating your clients on how the ETF you’ve chosen can help support their goals.
Step 2: Explore exposures.
There was a time when the majority of ETFs all offered similar exposures. But now that there are so many new and diverse options, it’s easy to miss unforeseen risks unless you take the time to understand how the underlying index is constructed and how that drives performance. How are securities selected? How are weightings assigned? What’s the potential for sector or stock biases? Indexes have evolved along with the industry, and it’s important to understand the implications of each type of construction and whether or not it aligns with your investment objectives. Look at all your options, be sure you understand the pros and cons, and choose what’s best for the portfolio.
Step 3: Consider liquidity.
Start with the understanding that trading volume does not equal liquidity. Every ETF holds a basket of securities, which means the liquidity of the ETF, depends not on one stock, but on the liquidity of all underlying holdings. It’s critical to understand if and when you can trade, and at what cost. Because liquidity isn’t always easy to determine, work with the issuer’s Capital Markets desk to answer your questions and guide you through the trading process. Ask specific questions—“If I placed a $10M trade, what impact would that have on the portfolio?”—and demand clear answers to help you make the best possible decision.
Step 4: Scrutinize costs.
While ETFs are renowned for their low fees, the total cost of ownership for an ETF is about much more than the fund’s expense ratio. To be sure you’re considering all aspects of cost, look closely at tracking error and how consistently the ETF moves with the index. Analyze live track records or compare a back test to the live track record history. Pay attention to bid/ask spreads, rebalancing costs, brokerage fees, and capital gains. Every additional cost impacts the total investment cost and, ultimately, the total value of the fund within the portfolio.
As the ETF market continues to evolve, your knowledge needs to evolve as well. By completing the necessary due diligence—either on your own or with the help of a trusted partner—you can sift through the massive menu in front of you and make choices that not only leverage the inherent value of ETFs, but also deliver the right strategy at the right time to help address your clients’ investment goals. The end result is likely to be much more satisfying than that slice of White Chocolate Caramel Macadamia Nut Cheesecake you’ve had your eye on. Here’s to smart choices!
Learn more about ETF due diligence at: www.jpmorgan.com/etfs
Opinions and statements of market trends that are based on current market conditions constitute our judgment and are subject to change without notice. These views described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results. Investment returns and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. ETF shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. For all products, brokerage commissions will reduce returns.
J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. J.P. Morgan Exchange-Traded Funds are distributed by SEI Investments Distribution Co, One Freedom Valley Dr., Oaks, PA 19456, which is not affiliated with JPMorgan Chase & Co. or any of its affiliates.
For additional disclosure: https://am.jpmorgan.com/us/en/asset-management/gim/adv/site-disclaimer
Understanding ETF Liquidity and Trading
Written by: ProShares
ETFs offer attractive features—access to a broad range of asset classes, sectors and styles in a liquid, transparent and cost-effective vehicle. But before using that vehicle, it’s helpful to understand how it works, especially the sources of ETF liquidity and the mechanics of trading them. Understanding these points may help you improve execution when buying and selling ETFs.
The Primary Market—Creation/Redemption of ETF Shares
Most investors trade ETFs on stock exchanges in the secondary market. But the actual creation and redemption of ETF shares occur in the primary market, between the ETF and authorized participants (APs)1—the only parties who transact directly with the ETF. The APs’ ability to continuously create and redeem shares allows them to meet the supply and demand needs of investors, making them key liquidity providers in the secondary market.
Creation. This is how APs introduce new ETF shares to the secondary market.
- In-kind—The AP creates ETF shares in large increments—known as creation units—by acquiring the securities that make up the benchmark the fund tracks in their appropriate weightings and amounts to reach creation unit size (blocks ranging from 25,000 to 100,000 fund shares). The AP then delivers those securities to the ETF in exchange for ETF shares.
- Cash—Alternatively, APs can create ETF shares by exchanging the appropriate amount of cash for ETF shares, for what’s known as a cash create. Often, ETF shares are created using a combination of securities and cash.
- The AP then offers the ETF shares for sale in the secondary market, where they are traded between buyers and sellers on an exchange.
Redemption. This follows the same process in reverse.
- The AP redeems ETF shares in large increments—known as redemption units—by acquiring them in the secondary market and transferring them to the ETF in exchange for the underlying securities or cash (or both) in the appropriate weightings and amounts.
The Secondary Market—Costs and Mechanics of Trading ETF Shares
Costs of Trading. In the secondary market, firms that specialize in buying and selling ETF shares—APs or market makers2 (liquidity providers)—trade them to provide market liquidity and make a profit. This profit margin is embedded in the bid/ask spread, which reflects the implicit costs of trading ETFs.
Bid/ask spread is the difference between the bid—the highest price at which a buyer is willing to buy shares—and the ask—the lowest price at which a seller is willing to sell ETF shares. Three key factors impact the bid/ask spread:
- Creation/redemption fees charged by the ETF provider to the AP.
- Spread of the underlying securities—The bid/ask spread and liquidity of the securities that make up the ETF affect the liquidity and the bid/ask spread of the ETF itself. When there are many bids and offers on a security, it is easy to buy and sell, thus the bid/ask spread tends to be tight. When securities are less liquid, the spread is wider, making the cost to acquire them higher. The higher the cost of acquiring the underlying securities, the wider the ETF bid/ask spread.
- Risk or hedging costs—Holding ETFs entails certain risks, which need to be hedged. Liquidity providers use a variety of financial instruments, including futures, options and other ETFs, to hedge this risk. The more instruments they have to choose from, the lower their hedging costs and the lower the bid/ask spread. The higher the risk, the wider the spread.
ETF bid/ask spread = Creation/redemption fees + spread of underlying securities + risk
Executing Large Orders—Tapping Into Deeper Pools of Liquidity
There are two common ways to execute larger trades directly with liquidity providers, both allowing investors to access deeper pools of liquidity than those offered in the quoted secondary market alone:
- Risk trade—A liquidity provider will quote a price for an ETF at a given size. If that price is accepted, the trade is executed and the liquidity provider assumes the market risk of providing the liquidity at execution.
- Create/redeem—For orders that are large enough, it may make sense to work with an AP to create or redeem shares. This type of transaction is usually executed at either the closing market price of the ETF or at the NAV of the ETF plus fees or commissions.
Mechanics of Trading. To fully consider an ETF’s total costs, it is important to understand the dynamics of trading. In general, two types of orders are commonly used to trade ETF shares:
- Limit order—Buy or sell ETF shares at a specified price. One way investors decide at what price to enter a limit order is to look at the IOPV3 as a guidepost. Limit orders may help investors get the best price, but there’s a risk the order will not be filled.
- Market order—Buy or sell immediately at the prevailing price available at the time. With market orders, execution may be faster, but the investor has limited control over the execution price.
While a large number of transactions are executed using limit or market orders, investors often find their order is larger than the quoted market. There may be “hidden” liquidity within the quote that can be accessed in the market using limit or market orders. However, in some cases, it may make sense to execute trades directly through a liquidity provider. How and when to place an ETF order can depend on many factors, including price sensitivity, level of urgency and overall goals for the portfolio. Determining what factors matter most can help determine the best execution strategy.
Questions? Our capital markets experts can help. Learn more about our ETFs here.
1 An AP is a U.S. registered, self-clearing broker/dealer who signs an agreement with an ETF provider or distributor to become an authorized participant of a fund.
2 A market maker is a broker/dealer that buys and sells securities (or ETFs) from its own inventory to facilitate trading in those securities. Most APs are market makers, but not all market makers are APs.
3 IOPV is the Indicative Optimized Portfolio Value—the intraday net asset value of the basket of underlying securities
Investing involves risk, including the possible loss of principal. ProShares are non-diversified and each entails certain risks, which may include risk associated with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. Please see their summary and full prospectuses for a more complete description of risks. Carefully consider the investment objectives, risks, charges and expenses before investing. This and other information can be found in the prospectus; read carefully before investing; obtain at ProShares.com. There is no guarantee any ProShares ETF will achieve its investment objective.
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