Advisors looking for cost-effective options for building diversified portfolios are continuing to turn to exchange-traded funds. And given their competitive strengths, it's no wonder ETF assets in the U.S. grew at nearly 40% compound annual growth rate from 1998 to 2009. ETF assets now total almost $1 trillion and represent 45% of total passive fund assets in the United States.

ETFs combine the benefits of an index mutual fund with the flexibility of a stock: they offer continuous pricing and intra-day trading; they can be borrowed and sold short; and in comparison to mutual funds, ETFs generally offer lower expense ratios, as well as greater holdings transparency and tax efficiency. When it comes to trading, however, there are some considerations advisors can take into account to make their utilization of these vehicles more efficient.

ETF Liquidity: More than Meets the Eye
Liquidity is an important factor in evaluating any investment. But the important thing to remember when considering an ETF investment is that liquidity cannot be measured simply by looking at secondary market trading volume.

Because of their unique creation/redemption process, a better indicator of an ETF's true liquidity is the liquidity of the fund's underlying securities. So-called "authorized participants" can create and redeem ETF shares at any time, as market conditions warrant. They can either create shares by buying a basket of securities and delivering them to the sponsor in exchange for ETF shares, or redeem ETF shares by delivering them to the fund sponsor, and then selling the recouped securities on the open market.

As long as the underlying securities are liquid, so too are the ETF shares. Even if the secondary market for the ETF shares themselves may look thin, based on intra-day trading volumes, the ETF itself is still quite liquid.

ETF Pricing
Another subtlety of ETF trading concerns pricing. ETFs are not purchased at net asset value (NAV) like mutual funds. ETF shares trade at market prices like stocks, and intra-day prices can vary due to changes in prices of underlying securities, as well as supply and demand dynamics for the ETF shares themselves.

It is important not to rely solely on the last sale to judge whether the market price for a specific ETF is fair, as it may no longer reflect current market conditions and values of the underlying securities. A better baseline is to look at the ETF's "indicative intra-day value," which is a calculation of an ETF's value based on the current market price of the underlying securities.

The indicative intra-day value has its own ticker and is updated and published continuously throughout the trading day. It is also important to note that for international ETFs, where markets for underlying securities may be closed, the indicative intra-day value may not accurately depict the current market value of the ETF.

For these products, the last trades and market quotes of price and depth are a good start, and other liquid instruments (peer group ETFs, futures contracts, individual stocks) with high correlations with the ETF may offer investors an additional gauge of current market values.

Targeting Optimal Execution
As with trading individual securities, investors should develop a thorough approach to trading ETFs to help ensure best execution. Factors to consider when developing a thorough trading approach include closely evaluating market, pricing and liquidity conditions. To gauge the quality of markets made on ETFs, as with stocks, investors can look at trade volumes, bid-offer spreads and the depth of markets made.

Higher volumes—both current and historical—tend to indicate high information flow and efficient pricing. When secondary volume is limited, look at the market being made to assess potential liquidity. And a check of the indicative intra-day value is always in order, to ensure ETF share prices reflect the fair market value of the underlying securities.

For investors with substantial orders, secondary markets may not reflect all sources of potential liquidity. Advisors should work with their broker/trading desks to tap alternative sources of liquidity, including creation and redemption through authorized participants.

We also suggest avoiding use of market orders for large trades, or when close monitoring is not possible. Limit orders give investors more control. In addition to reducing market impact, they may help buyers avoid sudden market shifts (e.g., the "Flash Crash" of 2010). Finally, just as with individual securities, bid/ask spreads for ETF shares can change over the course of a trading day, so ensuring optimal trade execution requires close monitoring until the entire trade is completed.

Exchange-traded funds have proven to be powerful, useful and efficient investment vehicles. Keep in mind that these subtle characteristics of ETFs and a few simple trading strategies may help you, as advisors, make even better use of ETFs to deliver even more value to your clients.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.