Broadly speaking, risk in the investing context is the possibility that an individual or institution may not reach their goals. And there are many risks to be aware of, such as interest rate risk, geopolitical risk, and counterparty risk. Let’s put those portfolio threats aside and focus on the Investment/Market Risks associated with ETFs. There are a number of risk metrics investors can use to see whether or not a given ETF is meeting its objective. It’s important to know what these metrics are—and it’s equally crucial to understand what constitutes a good number, and what suggests cause for concern. To use a baseball analogy, knowing what slugging percentage represents is only half the battle—the savvy fan can put a player’s figure in context, making an informed conclusion as to how good a hitter someone truly is.

Is Your ETF Doing Its Job? The Importance of Tracking Difference

Although active ETFs have become more prevalent, the most popular funds are still passively managed. Whether or not a passive ETF increases or decreases in value, it’s crucial to know whether the fund is “doing its job.” In other words, is a given passive ETF reflecting its benchmark index, or meaningfully straying from it? This is where a metric known as Tracking Difference can be used. Tracking Difference is the discrepancy between ETF performance and index performance over a specified period of time. For passive ETFs, Tracking Difference is arguably the most important risk metric to follow.

Every ETF will have some element of Tracking Difference. For one thing, an ETF’s total expense ratio (TER) can always be expected to contribute to Tracking Difference, as it creates an exact drag on the fund’s performance compared to its index. In this vein, investors obviously benefit from a lower TER, as this minimizes the gap between an ETF’s performance and its benchmark index.

A Fund’s Tracking Difference Can Also Be Impacted by Other Factors, Such As:

• Cash Drag: In a bull market, a portfolio that holds cash will tend to underperform an index with no cash component.

• Sampling: Some ETFs engage in what’s known as “Full Replication”—owning all components of an index. Other ETFs, though, ‘sample’ a majority of the index components—owning most, but not all, of its securities. By not fully replicating an index, an ETF is exposed to Tracking Difference (positive or negative).

• Securities Lending: Many ETFs earn extra income by lending out shares to short sellers. On the one hand, this practice can improve a fund’s performance. However, there are a couple of risks. First, if a security that has been lent out soars in value and bankrupts a short seller, the borrowed shares may not be returned. This turn of events would mean the ETF would not benefit from the security’s jump in price, leading to underperformance relative to the index. To be clear, this is a rare event. To protect the lender from risk of loss, lent securities are always collateralized using cash or securities, commonly government debt. Cash collateral is more common in the United States, while Europe tends to favor noncash. This is common practice for ETFs.

• Trading Costs: When an ETF buys or sells securities (to re-balance, for example), it incurs trading commissions. These costs also cause the ETF’s performance to deviate from that of the index.

From Tracking Difference to Tracking Error

Tracking Difference is a measure of whether an ETF is keeping up with its index, but Tracking Difference fluctuates over time. That’s where a measure known as Tracking Error can be employed. Tracking Error is essentially the volatility of an ETF’s Tracking Difference. The lower the number, the better. Tracking Error shows you if the tracking difference is relatively consistent, or if it varies wildly over the course of the year.

Some investors conflate Tracking Difference with Tracking Error. They see a high Tracking Error and conclude that a given ETF isn’t properly following its index. In reality, the Tracking Difference may simply be low but volatile.

It’s important to note that, for the purpose of Tracking Difference and Tracking Error calculations, an ETF’s performance can be measured by price or Net Asset Value (NAV). Price is based on the perceived value of the fund by buyers and sellers in the market, while NAV is based on the prices of the underlying securities and their weights making up the fund. NAV may have fewer uncontrollable variables impacting its measure of performance, arguably making it the better choice.

Other Passive Measures of Risk

In addition to Tracking Difference and Tracking Error, there are two other key metrics used to measure ETF risk for passive ETFs: Beta and Standard Deviation.

Beta is a measure of an ETF’s volatility relative to the market. By definition, the overall market’s Beta is 1.00. An ETF with a Beta greater than 1.00 has exhibited more volatility than the market over a specified period of time. In contrast, an ETF with a Beta less than 1.00 has been less volatile than the overall market.

Beta is also a function of correlation: An ETF with a positive Beta (greater than 0) is positively correlated with the overall market, whereas an ETF with a negative Beta (less than 0) is inversely correlated to the overall market. Most passive ETFs will have a positive Beta. Sectors that tend to exhibit high levels of volatility will have a positive Beta greater than 1, and more defensive sector ETFs will have a Beta that is positive but less than 1. Examples of passive ETFs that may, depending on the market environment, have a negative Beta, include inverse ETFs (exchange traded funds that use derivatives to achieve the opposite returns of a specified benchmark), and government bond ETFs.

Standard Deviation compares the long-term average return of an investment to the shorter-term returns it achieved along the way. It’s common to look at the historical average returns of an investment when deciding if it’s a good opportunity. But average returns don’t tell the whole story. Suppose two ETFs both average a 7% return over the past 10 years. But when looking at individual years, one returned 7% every year while the other had some years with double-digit performance, and others with low single digit returns. Clearly, the ETF that rose 7% each year displayed lower volatility than its counterpart—and likely took less risk to achieve the same long-term return.

It’s crucial to note that Standard Deviation includes both upside and downside volatility. So, a high number could indicate increasing returns, decreasing returns, or a combination of both.

Active Measures of Risk

Passive ETFs may still dominate, but active products are becoming increasingly popular with investors. Fortunately, we also have measures of risk to assess these ETFs as well. As with passive ETFs, investors can use both Beta and Standard Deviation when judging whether an active product is meeting its objective.

In addition, there are two key risk metrics specifically applicable to active ETFs:

• Alpha: A measure of how an ETF performs relative to a particular index or benchmark over a specified period of time, after adjusting for volatility. Alpha offers a window into the ‘active’ performance of an ETF, allowing investors to see whether a fund is outperforming or underperforming a passive benchmark. This measure is expressed as a percentage. For instance, an ETF with an Alpha of 3% will have exceeded its benchmark by this amount, after taking into account the volatility of the fund’s portfolio.

• Sharpe Ratio: A measure of an ETF’s excess returns relative to its volatility. The Sharpe Ratio indicates how much excess return is generated per unit of risk taken, and a higher number implies that an investor is being compensated for taking on extra risk with relatively outsized returns. The Sharpe Ratio gives investors a sense of whether an active ETF fund is taking a substantial amount of risk in order to generate outperformance. Ideally, an ETF is delivering above average returns with low volatility. The Sharpe Ratio is also expressed numerically (the higher the better), with anything above 1 considered to be good.

Sidebar: Liquidity Risk

ETF investors are also faced with potential liquidity risk. This is especially true if a significant portion of a fund’s assets are concentrated in thinly traded securities. An ETF’s liquidity is tightly linked to the liquidity of its underlying holdings. As a result, a fund that has a large weighting in small companies with large bid-ask spreads and low volume will usually have poorer liquidity than a fund, which predominately owns large-capitalization stocks with tighter spreads and high daily volume.

Conclusion

ETFs have specific roles to play in an investor’s portfolio. There’s no guarantee that a given ETF will rise in value, as any number of market factors could lead to a decline. But whatever the market environment, it is crucial that the ETF is performing its role correctly. Investors should look at the key risk metrics for a given fund to see whether the ETF is truly “doing its job.” That can help determine whether it’s a hold, or if it’s time to sell and move on to a product more likely to meet their objective.

This resource is brought to you by NASDAQ

Distributed by NASDAQ CAPITAL MARKETS ADVISORY, LLC, a Registered Broker Dealer and affiliate of Nasdaq, Inc.

Investment Risks

Exchange Traded Products (ETPs) are types of securities that derive their value from a basket of underlying securities such as stocks, bonds, commodities, etc., and trade intra-day on a national securities exchange. Generally, ETPs take the form of Exchange Traded Funds (ETFs) or Exchange Traded Notes (ETNs). Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

Exchange Traded Funds (ETFs) are subject to market risk, including the possible loss of principal. The value of the portfolio will fluctuate with the value of the underlying securities. ETFs may trade at a premium or discount to their net asset value. ETFs may have underlying investment strategy risks similar to investing in commodities, bonds, real estate, international markets or currencies, emerging growth companies, or specific sectors.

Diversification is not a guarantee against loss.

Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

© 2023. Nasdaq, Inc. All Rights Reserved.

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Diversify Your Portfolio

We’ve all heard the adage, “Don’t put all your eggs in one basket.” In an investment context, this advice speaks to the importance of being properly diversified. Diversification can enhance risk-adjusted returns over time, protecting a portfolio against a sharp drop in one holding or asset class. Exchange traded funds can offer compelling benefits in terms of diversification. From an asset allocation standpoint, owning ETFs can complement and augment the other building blocks of an investor’s portfolio—whether that’s cash or cash equivalents, individual securities (equities or fixed income), or alternative investments (e.g. private equity, hedge funds, real estate, etc.).

Meanwhile, exchange traded funds allow for diversification because they offer investors access to such a wide range of stocks and bonds. There are ETFs that seek to track broad market indices (such as the Nasdaq-100®), strategies that complete parts of a portfolio such as value, growth, or income, as well as funds that focus on specific countries or sectors. Each investor
can buy the mix of ETFs that helps to meet their unique needs and objectives.

Individual and institutional investors can also choose from passive and active exchange traded funds. Passive ETFs buy and hold a basket of securities, which are typically representative of an index, sector, or country. Unlike, say, a traditional active mutual fund, a passive ETF does not have portfolio managers who aim to buy certain securities (and avoid others) in a quest for outperformance. These types of ETFs often sport ultra-low fees, as the fund provider doesn’t need to maintain expensive teams of analysts and portfolio managers.

While passive funds still dominate the ETF space, investors now have increasing access to actively managed exchange traded funds. These function in the same way as traditional (i.e. passive) ETFs but have professional managers at the helm buying and selling in a bid to outperform an index or other benchmark. Active ETFs do tend to come with somewhat higher fees, but they also have the potential of outperforming their benchmark.

Low Cost and Easy Access

Two features that have made ETFs so popular are their low fees and their ease of access. Take cost, for starters. Compared to mutual funds, exchanged traded funds have rock-bottom management expense ratios (MERs).

ETF fees usually range from around 0.1%-0.45%, depending on the strategy and whether they are passively or actively managed.

ETFs are also super-easy to access. Anyone with a brokerage account (whether it’s self-directed or through an advisor) can buy and sell ETFs. Indeed, with online trading, this can literally be done with the click of a few buttons. What’s more, the management fees associated with owning an ETF tend to be very inexpensive. To use a simplified example, an investor who buys $10,000 of an ETF with a 0.1% management expense ratio would pay $10 to the fund provider each year. Trading costs (which are paid to an investor’s broker) are a separate cost.

Exchange traded funds are accessible in another way as well: there’s no minimum purchase. This makes them ideal for individuals who are just starting to build a portfolio. Mutual funds, on the other hand, typically require a minimum investment.

Intra-Day Trading

Another advantage of ETFs is that you can buy and sell them throughout the trading day. So, while we don’t recommend attempting to time the market, you do have the ability to respond to market changes as they happen. Intra-day trading is also crucial because it allows investors to buy and sell a holding instantaneously. This allows you, for instance, to quickly raise funds if you spot another investment opportunity.

You don’t have to wait for the close of trading to know the price you’ll receive, either.

Intra-day trading is available for all ETFs, including those that trade less frequently. For those ETFs, which can have more price fluctuations, it is best practice to use a limit order or wait until after the market has been open for an hour or so.

Tax Efficiency

Returns matter for investors, but what really matters are after-tax returns. Fortunately, the way exchange traded funds are designed can help minimize the taxes paid by investors holding the ETF. Without going into too many details, ETFs can engage in ‘in kind’ transactions for their underlying securities, which avoid the realization of capital gains. This leads to lower capital gains taxes pay able for those who hold an ETF in their portfolio. So, while investors will still realize capital gains for the increase in their purchase price vs. their sale price, trading activity
within the ETF likely won’t have any tax implications.

Price Efficiency

Price matters. Whether you’re buying a sweater, a car, or an ETF, you want to feel confident that you won’t pay more than something is currently worth or sell for less than you could get. The good news is that exchange traded funds have two mechanisms that contribute to the price efficiency. First, each ETF has one or more designated Authorized Participants. These are typically brokerage firms or other trading companies. Authorized Participants may deal both in a given ETF, as well as that ETF’s underlying assets—creating and redeeming units of a fund in the process.

If the market price of an ETF is trading at a discount to its Net Asset Value (NAV)*, an Authorized Participant (AP) can deliver units of the ETF to the fund’s provider, taking the ETF’s basket of securities in return. On the flip side, if an ETF is trading at a premium to its NAV, an AP can profit by doing the reverse: Buying securities and delivering them to the fund provider in exchange for ETF units. This kind of arbitrage is profitable for the Authorized Participant and brings the market price of a fund in line with its value.

A second layer of price efficiency in ETFs arises due to the actions of what are known as Market Makers. Market Makers are trading firms designated to provide liquidity when required. These firms post bid and ask quotes throughout the trading day, giving prospective buyers and sellers the ability to trade in an ETF. As with Authorized Participants, Market Makers can help arbitrage away any significant premium or discount in an ETF relative to its underlying NAV—buying if an ETF is trading at a discount and selling if it’s trading at a premium.

Transparency—Know What You Own

A final but still crucial benefit of ETFs is their transparency. In other words, investors know what they’re buying, and they know what they’re selling. ETFs differ in the amount of transparency they provide, but in both cases, there is sufficient disclosure for someone to make an informed decision.

Fully transparent ETFs publish their complete list of holdings daily. That means the market knows at the end of each trading day which securities an ETF owns—and exactly how many. Semi-transparent ETFs, on the other hand, shield some level of detail to protect their investment process. To facilitate transparency, these funds publish what is known as an indicative NAV. Usually updated every 15 seconds throughout the trading day, an indicative NAV tells the market what a fund’s underlying holdings are worth. Semi-transparent ETFs also publish a proxy basket for Market Makers: While not a fund’s actual portfolio holdings, this basket is designed to be sufficiently representative so as to encourage trading firms to keep providing liquidity to the market.

A Note on Notes

This primer has delved into the world of exchange traded funds, but there are other exchange traded products including exchange traded notes (ETNs). ETNs, one of the many exchange-traded products out there, are very different than ETFs. Most importantly, an ETN represents an unsecured liability on the part of its issuer (often a bank). If, for whatever reason, the issuer cannot make good on its obligations, investors in an ETN could suffer losses, even if they were correct in choosing a particular sector or market. Contrast this with ETFs, which are their own standalone structure, that hold securities on behalf of the fund’s investors.

ETFs are Here to Stay

From virtual obscurity a few decades ago, ETFs have become a household term. They have revolutionized the investing world, allowing individuals and institutions to access a wide variety of strategies in a low cost, tax-efficient manner. For its benefits, it seems a safe bet that the exchange traded fund is here to stay.

This resource is brought to you by NASDAQ

Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

© 2023. Nasdaq, Inc. All Rights Reserved.

The post Key Benefits Of ETFs appeared first on REX Shares.

Active vs. Passive ETFs Defined

Passive ETFs are designed to track a particular index or sector — and, hence, do not aim to “beat the market.” Rather, they tend to own a basket of securities (based, for example, on market capitalization). The buying, selling and rebalancing process for these strategies is based on a specific set of rules outlined in the product’s methodology.

While they can be rebalanced occasionally if, say, an index is altered, they don’t engage in buying or selling for the purpose of generating excess returns.

Active ETFs, by contrast, are designed with the goal of outperforming a benchmark index or sector. Helmed by professional fund managers, these ETFs may employ a proprietary mix of quantitative and qualitative investment strategies to inform buy and sell decisions. Ideally, an active ETF will deliver ‘alpha’ to investors, that is, a risk-adjusted return that beats a given benchmark.

Why Investors Might Choose Either an Active or Passive ETF

Both styles of ETFs have merits. Passive ETFs might be the right choice for investors who seek index-like returns and prioritizes very low fees. Meanwhile, investors may gravitate toward active ETFs due to a desire to outperform the market — and a belief that their ETF is led by professional managers with the ability to do so.

Source: Nasdaq, as of Oct 23

Differences in Benchmarking: Active vs. Passive ETFs

Active ETFs have more flexibility to choose their reference benchmark or even to choose multiple benchmarks. Active ETF managers can then use the securities and financial instruments within their stated strategy to attempt to outperform their benchmark(s). Conversely, passive ETF managers can choose a specific method to track their one benchmark. Their selection methodology can be full replication, optimization or synthetic replication.

• Full Replication: The ETF holds every security at the same weight as in the benchmark index.

• Optimization: When an index includes more constituents or difficult-to-trade constituents than the ETF can handle in terms of trading costs, the ETF will
hold an optimized sample of the index in terms of costs, correlations and exposure.

• Synthetic Replication: The ETF does not buy the underlying securities of its index and instead uses derivatives to swap the performance of the index for a defined fee. Full disclosure happens on a monthly basis.

Almost all fixed income ETFs use an optimization approach because most fixed income indexes hold thousands of bonds that may or may not have traded recently. The fixed income portfolio manager will utilize a more liquid sample of the bonds to replicate the desired performance.

Smart Beta ETFs: A Hybrid Approach to Investment Management

ETFs that combine elements of active and passive approaches employ so called Smart Beta strategies and do not track a straightforward index like the Nasdaq-100® or S&P 500. Rather, these strategies create a more complex set of screening, filtering, weighting and/or rebalancing rules. This could be interpreted as a hybrid approach because it takes the guidelines an active manager may follow and codifies them into a new Smart Beta index that an ETF can track.

Issuers have expanded into launching ETFs focusing on one or more factors that are meant to be used to outperform different parts of the economic cycle as well.

Smart Beta, defined:

Using a rules-based approach instead of discretionary stock-picking.

Source: Nasdaq, as of Oct 23

Mutual Fund and Separately Managed Account Conversions to ETFs

The popularity of ETFs among investors shows no signs of abating. As a result, some mutual funds, as well as separately managed accounts (SMAs), are converting to ETFs. Conversions allow for active management offered in a form that can be more tax-efficient, more liquid, more transparent, more accessible (intraday trading/can be purchased on a simple brokerage app) and potentially with lower fees than mutual funds or SMAs. Converting is not without its hurdles, however. The switch from a mutual fund or SMA to an ETF involves operational challenges, significant communication with investors, and in some cases, shareholder approval.

Number of Mutual Fund to ETF Conversions

Source: Nasdaq, as of Oct 23

Conclusion

The scope of ETFs has broadened considerably in recent years. Investors can still access a wide range of passive vehicles, but now have the choice of adding active ETFs to their portfolios. To help ensure you own the ETF that best fits your objectives, understanding the nuances behind the different products is a must.

This resource is brought to you by NASDAQ

Distributed by NASDAQ CAPTIAL MARKETS ADVISORY, LLC, a Registered Broker Dealer and affiliate of Nasdaq, Inc.

Investment Risks

Exchange Traded Products (ETPs) are types of securities that derive their value from a basket of underlying securities such as stocks, bonds, commodities, etc., and trade intra-day on a national securities exchange. Generally, ETPs take the form of Exchange Traded Funds (ETFs) or Exchange Traded Notes (ETNs). Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

Exchange Traded Funds (ETFs) are subject to market risk, including the possible loss of principal. The value of the portfolio will fluctuate with the value of the underlying securities. ETFs may trade at a premium or discount to their net asset value. ETFs may have underlying investment strategy risks similar to investing in commodities, bonds, real estate, international markets or currencies, emerging growth companies, or specific sectors.

Diversification is not a guarantee against loss.

Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

© 2023. Nasdaq, Inc. All Rights Reserved.

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Think of an exchange traded fund (ETF) as a wrapper or a box. It’s simply the packaging that holds a group of securities based on its investment objective. One ETF may track a specific index, like the Nasdaq-100®, another may be actively managed and purchase stocks of only biotech companies or only healthcare companies, while another may focus on bonds from various municipalities. Regardless of the investment objective, the important thing to remember is that each ETF is made up of different individual pieces. As we’ll discuss later, the ability to assemble, break down, and reassemble those individual pieces, called the creation and redemption processes, is what drives both the liquidity and the potential tax benefits of ETFs.

ETFs offer investors important advantages compared to mutual funds. First, an investor who’s looking to buy or sell a particular ETF doesn’t have to wait until the end of the trading day to complete a transaction. ETFs can be bought and sold whenever the market is open. In addition, ETFs also sport higher levels of daily transparency than mutual funds, as most ETFs publish their underlying holdings daily.

ETFs Under the Hood: The Primary and Secondary Market Players

After a buyer (retail or institutional) places an order for an ETF, there are multiple ways traders can source the shares for that end-investor’s account. ETF traders can operate in two markets: on the secondary market, which involves buying and selling shares that currently exist on an exchange, or on the primary market, where ETF share creation and redemption orders take place. The creation order process results in new shares of the ETF being made from an ETF’s individual holdings and added to the previously existing ETF shares outstanding on the exchange. Conversely, the redemption order process breaks down existing ETF shares into their individual components and removes them from the pool of ETF shares trading on the exchange. Here’s a rundown of the ETF transaction lifecycle for a buy order and the key players involved in the ETF primary and secondary markets:

• Investors: From individuals to institutions, investors are the end-buyers or end-sellers of ETFs.

• ETF Issuers: Issuers are the companies that sponsor ETFs, list them on an exchange (such as Nasdaq) and manage the fund. When a new ETF comes to market, it’s funded with seed capital — typically from a bank, a major investor, or the ETF issuer itself. The seed capital is used to buy the securities that will form the initial shares of the ETF listed on the exchange.

• Exchange: Exchanges, like Nasdaq, are regulated platforms where companies/issuers can list their shares, and traders meet to buy and sell. Exchanges host the secondary market.

• Authorized Participants: Authorized Participants (APs) are allowed to place creation and redemption orders directly with ETF issuers. This allows APs to give issuers underlying holdings to receive created ETFs shares, or to redeem existing ETF shares with issuers to receive the underlying holdings. APs are typically banks but can be any self-clearing broker-dealer either acting as an agent, processing creations and redemptions on behalf of investors or market makers, or acting as a principal, creating and redeeming when it’s profitable for managing their own exposure. Market Makers can also be APs acting in a principal capacity.

• Market Makers: ETF Market Makers (MMs) are trading firms that specialize in facilitating the buying and selling of ETF shares on the exchange, offering ongoing daily access to ETF shares for investors. Market Makers buy when investors want to sell and sell when investors wish to buy — and profit on the difference in price between those transactions. They may also have APs submit creation and redemption orders on their behalf.

How is This Different Than Mutual Funds?

ETFs and mutual funds similarly can create and redeem shares directly with the issuer, but ETFs unlock an additional type of ability to trade shares by being listed on the exchange. The amount of ETF shares being bought or sold on the exchange is an ETF’s secondary market trading volume, or average daily volume (ADV). A security’s average exchange volume is a good barometer for the amount that can be bought and sold on the exchange without significantly moving the price of the security. The primary and secondary markets comprise ETFs’ layers of
liquidity (availability to buy and sell): the first liquidity layer emerging from preexisting ETF shares’ trading volume, and the second layer arising from the ability to create or redeem ETF shares. While every mutual fund transaction results in the purchase or sale of the underlying holdings of the fund, only creations and redemptions result in a change to shares outstanding, and therefore assets under management (AUM) for an ETF. Due to many ETF transactions taking place in the secondary market, ETFs buy or sell their underlying holdings less frequently than a mutual fund, impacting the underlying securities less often.

A Primary Market Creation Example

As we now know, when an investor purchases ETF shares, the delivered shares can be sourced from preexisting ETF volume via the secondary market or new shares of the ETF created from underlying holdings via the primary market. From a buyer’s perspective, this is akin to a customer at a farmer’s market stand looking to purchase corn bushels. The salesperson working the stand can source the corn bushels from the existing supply for sale at the stand, representing the secondary market, or new bushels that could be made from the farm’s cornfield, representing the primary market. If the cornfield is plentiful, or the holdings making up the ETF shares have high trading volumes, it is very easy to create these new bushels of corn, or new ETF shares.

What happens when there is a large order, but low volume?

If an investor wants to purchase a much larger amount of an ETF than it trades on an average day, the Market Maker can simply use an AP to create these ETF shares in the primary market on their behalf. This is similar to a customer wanting to buy more bushels of corn than currently exist at the farmer’s market stand, and the stand salesperson asking the farm worker to get as many bushels as the customer needs. Hence, the farm stand’s existing bushels of corn, or the ETF’s ADV, is only a small portion of the total amount available for purchase. An ETF’s total liquidity is comprised of the ETF’s ADV plus the trading volume of the ETF’s least-traded underlying holding.

What about ETFs with high volume?

ETFs with greater volume, indicating more buyers and sellers willing to transact, usually have narrower spreads than those with lower volume. The difference between the Bid and Ask is the cost to buy and sell the ETF and is known as the Spread. The Bid is the highest price at which another market participant is willing to buy shares at, while the Ask is the lowest price a prospective seller is willing to transact. A narrow-spread means that enough buyers and sellers are ETFs with greater volume, indicating more buyers and sellers willing to transact, usually have narrower spreads than those with lower volume. The difference between the Bid and Ask is the cost to buy and sell the ETF and is known as the Spread. The Bid is the highest price at which another market participant is willing to buy shares at, while the Ask in close alignment on the value of the ETF and can transact efficiently. Another key determinant of ETF spreads is the liquidity of the underlying securities themselves: ETFs which own highly liquid stocks or bonds will tend to have narrower spreads than ETFs that own less liquid securities.

Two-Part Tradability Benefits

APs play a vital role in maintaining ETF pricing efficiency.

If the ETF’s price is higher than the fair value of its underlying holdings (its Net Asset Value), the Authorized Participant will buy the underlying holdings of the ETF, pass these holdings to the issuer to create ETF shares (in the primary market), and sell the ETF shares trading at a premium on the exchange (i.e. the secondary market), profiting on the difference. This process brings the ETF’s price down and back in line with the value of its holdings. Contrastingly, if the ETF’s price is lower than the fair value of its underlying holdings, the AP would buy the cheap ETF shares on the secondary market and redeem the shares in the primary market, profiting on the sale of the underlying holdings. This would eventually bring the ETF’s price up, eliminating much or all of its discount to Net Asset Value.

It is important to note that the AP and ETF issuer aren’t selling shares back and forth — they’re passing them in and out of the fund “in-kind” through the creation and redemption processes. The difference may seem trivial, but this ability to create and redeem ETF shares in-kind is what makes Exchange Traded Funds much more efficient from a tax perspective than mutual funds.

When a stock (or bond) is purchased, that purchase price is captured for tax purposes as “cost basis.” Any increase or decrease in value is measured against that basis in terms of taxable gains or losses. If I purchased a share of Kraft Heinz stock (Nasdaq: KHC) for $32 per share, that becomes my cost basis. If I sold it for $40 per share, the $8 gain is (potentially) taxable. Each transaction involving a realized gain or loss is known as a taxable event.

For mutual funds, every time a shareholder adds new money to the fund, the underlying securities must be purchased. Likewise, when a shareholder redeems his or her shares, the underlying securities are sold to generate the cash needed to pay out the proceeds to the shareholder. Taxable events thus accumulate throughout the year. At year-end, the fund’s investors may receive a taxable distribution or “Capital Gains Distribution,” representing the gains generated by the fund’s transactions passed along to the investor.

ETFs, on the other hand, through the creation and redemption process, allow the Issuer and the AP to minimize taxable events by exchanging ETF shares and underlying securities “in-kind” when possible, making capital gains distributions less likely. In this way, an ETF investor’s capital gains are not influenced by other investors entering and exiting the fund. Always consult a tax professional for specific advice or recommendations.

Arbitrage

The process of buying in one market and selling in another to profit from price discrepancies. Arbitrage by Market Makers and Authorized Participants helps to keep the price of an ETF close to its Net Asset Value (NAV).

Conclusion

It’s important for investors to understand how the primary and secondary markets power many of the unique benefits of ETFs. The ETF ecosystem is vast, with multiple participants tasked with providing access, liquidity, and fair pricing. Add tax efficiency into the mix, and it’s easy to see why ETFs have become the vehicle of choice for so many investors.

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Investment Risks

Exchange Traded Products (ETPs) are types of securities that derive their value from a basket of underlying securities such as stocks, bonds, commodities, etc., and trade intra-day on a national securities exchange. Generally, ETPs take the form of Exchange Traded Funds (ETFs) or Exchange Traded Notes (ETNs). Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

Exchange Traded Funds (ETFs) are subject to market risk, including the possible loss of principal. The value of the portfolio will fluctuate with the value of the underlying securities. ETFs may trade at a premium or discount to their net asset value. ETFs may have underlying investment strategy risks similar to investing in commodities, bonds, real estate, international markets or currencies, emerging growth companies, or specific sectors.

Diversification is not a guarantee against loss.

Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

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