My original blog (ETF Capital Markets Corner) has been around since 2016. For those who have been reading from the very beginning, you are very aware of the amount of ink spent discussing and debating some of the misconceptions regarding exchange-traded fund (ETF) liquidity. I would like to think that this audience—and investors more broadly—are now more comfortable trading newer funds, irrespective of their size or trading volume.
One of the points I made when highlighting the flaws of using average volume as a liquidity metric was that ETF net asset value (NAV) trades do NOT count in the official volume calculations. (See my prior posts, When Volume Doesn’t Tell the Whole Story and Revisiting (Again!) the Problems of ETF Volume). Not only does trading volume ignore how much the underlying basket of the ETF trades, but it also ignores a potentially large pool of block trades executed in the NAV markets.
Missing from those posts was a broader discussion on the NAV trades themselves. This is a topic that is starting to get a bit more attention, especially now that mutual funds have begun converting to ETFs and those mutual fund investors are accustomed to trading at NAV.
Before I dive into the different flavors of ETF NAV trading, let’s first review the reasons investors love ETFs (and why mutual funds are being converted to them). I think these are my top four:
- Tax efficiency
- Low costs
- Daily transparency
- Intraday trading
For the first two reasons, other things being equal, you most certainly would prefer your investment be tax efficient and low cost than tax inefficient and expensive. For the last two, there is a real possibility that you shrug your shoulders at one or both. For daily transparency, I am sure there are plenty of investors who are not checking the portfolio holdings every single day. For many long-term investors, the value of intraday trading is minimal at best.
We can apply that last point to mutual fund investors, especially those who might be entering the ETF world for the first time. Mutual fund investors are not concerned with intraday trading because that is not how they work! We often say that ETFs are like mutual funds except you have the option to trade at any point during the day. But no one says you need to exercise that option.
Thus, for this effort, let’s discuss how we can make the ETF trading experience just like the mutual fund investment experience. My basic understanding of buying an equity mutual fund:
- No matter what time the order is submitted during the trading day, the investor gets that day’s NAV.
- For mutual funds that hold US stocks, that NAV will be based on the closing price of those US stocks.
- For mutual funds that with international holdings, there might be a fair value adjustment to those international stocks when calculating the fund’s NAV.
ETF intraday trading is simply a mix of those three elements continuously calculated throughout the day. To understand the intraday price of an ETF, start with the value of the underlying stock and then adjust for closed international equity markets as needed (in the ETF world we call this “price discovery.”)
For an ETF to have that mutual fund feel, investors want that last closing price no matter what time they submit their order during the trading day. To achieve this, investors need to use a market-on-close (MOC) order type to buy or sell at last closing price.
Thus, for mutual funds that might make sense within an ETF wrapper, it’s imperative for the ETF issuer to work with both the listing exchanges and ETF market makers to ensure that the MOC order works as intended. I talked about closing auctions during the Market Structure Madness event of 2018, and these order types can work great when ETF market makers are prepared for them. The end (of day) result is that instead of buying a mutual fund for a certain amount of dollars, you will buy a certain number of shares of an ETF using the MOC order. For advisors who are not as familiar with trading ETFs, their overall experience should be the same.
One last point before wrapping up this discussion. The MOC order is different than trading at NAV. NAV trades (as the name suggests) are usually larger size trades whose price is based on the ETF’s official NAV. Typically, the official NAV is not known until very late on the day of trading. Thus, NAV trades are printed before the market opens on the next trading day, which, back to my earlier comment, is why they do not count as part of the ETF’s official trading volume.
Both MOC and NAV trades have their uses for all investors. However, for current mutual fund investors making their first leap to ETFs, it is the MOC order that will likely make them feel most at ease.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those offering potential for higher returns are accompanied by a higher degree of risk.
For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.
ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
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