ETFs: The Reality Is They Work

Includes: EEM
by: David Fabian

The June swoon in the equity, bond, and commodity markets has just about every pundit weighing in on the price action of exchange-traded funds. I have seen these experts talk about the disconnect between an ETF's current trading price and its intraday net asset value (or iNav for short). I have also seen such outlandish claims as speculation that leveraged ETFs are the root cause behind large single day moves in the market.

I think that it's reckless to make generalized statements about the ETF industry as a whole and specialized circumstances should be viewed in the context of heightened volatility. The reality of the situation is that 99.99% of the time ETFs trade on an exchange at or near their net asset value as shares are created and redeemed by market makers, authorized participants, and ETF sponsors. The more liquid the underlying stocks, bonds, or commodities, the easier it is for the ETF to work seamlessly on behalf of the buyer and seller to create a tight market.

Problems do occur on occasion in thinly traded markets or when investor redemptions exceed the capability of the ETF provider to redeem shares. In rare circumstances an ETF can trade away from its iNav which was the case last week with the iShares MSCI Emerging Market ETF (NYSEARCA:EEM) which briefly traded at a discount. Headline seeking journalists may have viewed this as an opportunity to pounce on the ETF industry as a whole and deride its shortcomings. However, the true story was that this was a very specialized circumstance that was due to a pickup in investor redemptions combined with global markets that the underlying assets trade on being closed.

Perhaps the more reckless statements last week were that ETFs exacerbate the selling on Wall Street or may ultimately cause a stock or bond crash. While there is no way to predict the next crash or prepare for its effects, I can assure you that ETFs are not going to be the root cause. When you step back and look at the larger picture, you will realize that ETFs are just a tool that are used like anything you have in your garage at home. It's the person that wields the tool that is ultimately responsible for how it affects the markets. If a hedge fund, high frequency trader, large bank, or other institutional investor decides to implement a strategy using ETFs that moves the markets, then they are ultimately responsible for that outcome.

Billions of dollars exchange hands every day in the ETF industry every single day and the majority of those transactions are smoothly met and received. Some of the reasons I love ETFs for my own account and my clients is that they are diversified, liquid, low-cost, and tax-efficient. I still believe that ETFs represent the future of investing and are an excellent alternative to high fee or underperforming mutual funds. They can also be an excellent alternative for individual stock investors that want instant exposure and diversification in a single vehicle that can be traded intra-day.

The question you should be asking is: How do I protect myself from these happenstance dislocations in the ETF marketplace so that I don't get burned?

1. Don't panic. ETF pricing dislocations typically occur on days where there is huge buying or selling volume as a result of investors piling in or out of those positions. You should try to focus on purchasing or redeeming ETFs when volatility is low and markets are functioning in an orderly manner.

2. Volume matters. The more heavily traded an ETF is, the more likely you will be able to enter and exit with tight pricing. This same rule applies for the underlying holdings of the fund that you wish to purchase. I would make sure that you use limit orders on thinly traded ETFs so that you are executed at a price that you control. You don't want to leave it up to a market maker to scalp you.

3. Do your homework. One of the easiest ways to research whether or not an ETF is trading at a severe premium or discount is at Morningstar. When you put in the ticker of an ETF or closed-end fund they will give you data on its current price, iNAV, and premium/discount. That way you know exactly how the fund is trading that day.

Don't make the mistake of just blindly following the herd when it comes to trading ETFs and you will find success with these innovative investment tools.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Fabian, Fabian Capital Management, and/or its clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.