Exchange-traded funds (ETFs) combine the advantages of diversification and money management found in mutual funds with the liquidity and tick-by-tick real-time trading found in stocks. Other advantages include cheaper transaction fees for ETF trading, tax-efficient structures, and a wide range of sectors/asset classes/focused investment schemes ideal for both traders and investors.
ETFs have grown in popularity over the previous decade as a result of these qualities. Each month, new ETF offers are put into the market. However, not all ETFs meet the short-term trading requirements of high liquidity, low cost, and price transparency.
According to a 2018 Investment Company Institute analysis, the U.S. ETF market remained the biggest in the world, accounting for 72 percent of the $4.7 trillion in ETF total net assets globally, with 1,832 funds and $3.4 trillion in total net assets at year-end 2017.
We’ll look at the key criteria that a trader or analyst should look for when choosing an ETF for short- to medium-term trading.
Liquidity (On and Off the Exchange)
The ease with which a given asset may be bought and sold is referred to as liquidity. The greater the consistency of trade volumes over several time windows, the higher the liquidity. Volume numbers for exchanges are often accessible on the exchange’s website. ETF units, on the other hand, trade off-exchange, and such transactions are recorded to the Trade Reporting Facility (TRF).A gold-based fund, for example, would desire to purchase gold ETF units off-exchange.
The more ETF trading that occurs off-exchange, the less attractive it is for regular traders, since it results in a lack of liquidity on the exchange. Traders should monitor TRF data closely and avoid ETFs with a high proportion of off-exchange trading.
ETFs are made up of underlying securities. The indicative net asset value (iNAV) is the underlying basket’s real-time valuation, which serves as “pricing advice” for ETF indicative prices. The actual ETF pricing may be higher or lower than theiNAV. TheiNAV may be sent at various times ranging from every 15 seconds (for ETFs on highly liquid assets such as stocks) to every several hours (for ETFs on illiquid assets like bonds).
Traders should seek for ETFs that publish high-frequency iNAVs and have a premium/discount price relative to the iNAV. The smaller the discrepancy between the iNAV and the ETF unit price, the more price transparency the ETF indicates for its underlying assets.
ETF Authorized Participants
Authorized participants (AP) in an ETF purchase and sell underlying assets depending on the demand and supply of ETF units. If there is a significant demand, an AP will purchase the underlying equities and send them to the ETF provider (fund house).In exchange, he receives the corresponding ETF units in huge aggregated “block sizes,” which he may sell in the market to meet expected ETF demand.
There are several APs for each ETF, and their efforts keep the pricing stable. This ETF trading approach may help you comprehend the following aspects while choosing ETFs.
Trading in ETFs is less expensive than trading in stocks or derivatives (or even than associatedmutual fund charges).This is because transaction expenses are handled by the APs rather than the ETF provider. However, not all ETFs carry modest fees.
ETF transaction charges may vary depending on the underlying asset. Futures-based ETFs, for example, may have greater fees than index-based ETFs. Traders who often purchase and sell ETFs for short-term trading should be wary of transaction fees, since they will reduce their earnings.
The block sizes used to produce ETF units may have a significant impact on price. While most ETFs have a basic block size of 50,000 units, a handful have larger sizes, such as 100,000. The best rates are assured for a conventional block size, however pricing for “odd lots” like 15,000 units may not be as good.
From a trading standpoint, “lower is better” depending on the available block sizes for creation units since small-sized standard lots have higher liquidity. When combined with daily liquidity figures (which indicate how often units are created/redeemed), ETFs with lower creation unit block sizes will better meet the needs of traders than those with big sizes.
Liquidity of Underlying Instruments
The liquidity of an ETF is proportional to the liquidity of the underlying product (s).Because even the smallest component of the S&P 500 has extremely high liquidity, an ETF like SPY (SPDR ETF) on the S&P 500Index may have a large trading volume with great liquidity and pricing transparency. It enables APs to swiftly establish and demolish ETF units.
The same may not be true for a bond-based ETF with an illiquid underlying bond, or an equity-based ETF with a restricted number of underlying companies (like SPDR MFS Systematic Core Equity ETF [SYE] that has only51 holdings).Traders should carefully research and choose ETFs with strong liquidity for the underlying securities, in addition to the ETFs’ own liquidity.
Daily Fund Inflow/Outflow
The end-of-day report for daily fund inflow/outflow shows the net amount of money invested in/withdrawn from an ETF. This report provides a sense of market sentiment for that specific fund, which may be utilized in conjunction with the other variables listed to evaluate an ETF for short- or mid-term trading methods such as momentum or trend reversal trading.
The Bottom Line
Not all accessible assets and asset classes are suitable for short- or medium-term trading, and ETFs are no exception. With the constant introduction of new ETFs into the market, it may be difficult for a trader to choose the ETF that best fits their trading approach. While the aforementioned points may assist a trader in avoiding naive hazards for ETF trading, traders are urged to completely acquaint themselves with anyETFs of interest and examine them to determine which meet their chosen trade strategy.
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