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.
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.
DISCLOSURES: This website is a general communication being provided for informational purposes only. It is educational in nature and not designed to be a recommendation for any specific investment product, strategy, plan feature or other purposes. By receiving this communication you agree with the intended purpose described above. Any examples used in this material are generic, hypothetical and for illustration purposes only. None of J.P. Morgan Asset Management, its affiliates or representatives is suggesting that the recipient or any other person take a specific course of action or any action at all. Communications such as this are not impartial and are provided in connection with the advertising and marketing of products and services. Prior to making any investment or financial decisions, an investor should seek individualized advice from a personal financial, legal, tax and other professional advisors that take into account all of the particular facts and circumstances of an investor’s own situation.
An Emerging Theme In Thematic Investing
Exchange traded funds (ETFs) are popular vehicles for market participants looking to engage in thematic investing. Thematic investing looks to take advantage of future growth trends, including disruptive technologies. Given that forward-looking approach, stock-picking in the thematic universe is equally as hard, if not harder, than in traditional market segments.
Go back to the late 1990s, before the bursting of the Internet/technology bubble. Back then, investors stood an equal chance of selecting E-Toys over Amazon or some no longer in existence networking equipment maker over Cisco.
“History is littered with examples of prospering industries with no indication of which company will come to dominate the industry,” according to Nasdaq. “This suggests that successful thematic investing is more about selecting baskets of investments rather than single securities.”1
The ALPS Disruptive Technologies ETF (DTEC) provides basket exposure to a broad swath of thematic investments. DTEC features exposure to not just one or two emerging technologies, but 10 such themes on an equal-weight basis.
The 10 themes represented in DTEC are as follows: 3D printing, clean energy, cloud computing, cybersecurity, data and analytics, fintech, healthcare innovation, Internet of Things (IoT), mobile payments and robotics and artificial intelligence (AI).
Generally speaking, fund issuers have been quick to respond to disruptive and transformative technologies, bringing products to market to tap these themes. Prior to DTEC coming to market late last year, there were ETFs devoted exclusively to cloud computing, cybersecurity, robotics and other themes featured in DTEC. However, few use the basket approach to themes employed by DTEC.
February, a rough month for U.S. stocks, highlighted the advantages of DTEC's multi-theme methodology. Seven of the 10 themes found in the fund finished the month lower, but DTEC was able to outperform the S&P 500 on a monthly basis.
Focusing on individual themes can be rewarding over the long-term, but not all investors have the risk tolerance for such a strategy. Consider this: the Indxx Global Robotics & Artificial Intelligence Thematic Index jumped more than 48% in 2017. That type of performance is enough to seduce many investors, but that same benchmark slipped 7.60% in February, generating monthly volatility of 34.10%.2 Said another way, that robotics and AI index's February slide was more than triple the loss experienced by DTEC during the month.
While it probably is not accurate to call the indexes devoted to individual disruptive themes “old,” many use old school weighting methodologies. For example, the two largest components in the ISE Cloud Computing Index are Netflix, Inc. (NFLX) and Amazon.com Inc. (AMZN). Only two members of the S&P 500 have larger market values than Amazon while Netflix currently has a larger market cap than Wal-Mart (WMT) and McDonald's (MCD).
Holdings subject ot change as of 12/31/17
For its part, DTEC not only equally weights its 10 disruptive themes, but its 100 components as well, potentially reducing single stock risk in the process. As the chart below confirms, equally weighting stocks is rewarding across sectors and market capitalization segments.
Past performance does not guarantee future results
Annualized returns for the past 10 years show seven of the 11 S&P 500 sectors, when equally weighted, outperform cap-weighted equivalents, according to S&P. Three of those seven sectors – financial services, healthcare and technology – are prominent parts of DTEC's roster.
1 Source: Nasdaq Dec. 28, 2015 https://www.nasdaq.com/article/what-thematic-investing-is-and-its-strengths-and-risks-cm559209
2 Source: ETF Replay data
An investor should consider the investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus which contain this and other information call 866.675.2639 or visit www.alpsfunds.com. Read the prospectus carefully before investing.
An investment in the ALPS Disruptive Technologies ETF (DTEC) may be subject to substantially greater risk and volatility than investments in larger and more mature technology companies.
There is no assurance that the market developments and sector growth based upon the themes discussed in the article will come to pass.
ALPS Disruptive Technologies ETF shares are not individually redeemable. Investors buy and sell shares of the ALPS Disruptive Technologies ETF on a secondary market. Only market makers or “authorized participants” may trade directly with the Fund, typically in blocks of 50,000 shares.
ALPS Advisors, Inc. (AAI) has engaged IRIS Werks, LLC (IRIS) to produce analysis and commentary on ALPS-advised ETFs. IRIS currently has a compensated business relationship with AAI. AAI is not affiliated with IRIS.
The content and opinions expressed in this article are that of the author and not the views and opinions of AAI. In addition, AAI assumes no responsibility to ensure the accuracy of the content written by the author.
There are risks involved with investing in ETFs including the loss of money. Additional information regarding the risks of this investment is available in the prospectus. Past Performance is not indicative of future results.
The fund is new and has limited operating history.
ALPS Portfolio Solutions Distributor, Inc. is the distributor for the ALPS Disruptive Technologies ETF. AAI is affiliated with ALPS Portfolio Solutions Distributor, Inc.
The author is not an investment professional and this article should not be considered investment advice. While the information and statistical data contained herein are based on sources believed to be reliable, the author takes no responsibility to ensure the accuracy of the content. Additionally, this article should not be relied on or be the basis for an investment decision. Information that is historical is not indicative of future results, and subject to change.
S&P 500®: A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
S&P SmallCap 600®: A capitalization-weighted index that measures the small-cap segment of the U.S. equity market.
S&P MidCap 400®: A capitalization-weighted index that measures the mid-cap segment of the U.S. equity market.
Indxx Global Robotics & Artifical Intelligence Thematic Index: The Indxx Global Robotics & Artificial Intelligence Thematic Index is designed to track the performance of companies listed in developed markets that are expected to benefit from the increased adoption and utilization of robotics and Artificial Intelligence ("AI"), including companies involved in Industrial Robotics and Automation, Non-Industrial Robots, Artificial Intelligence and Unmanned Vehicles.
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