ETFs: sorting fact from fiction (Part 1)

BY David Bassanese | 12 July 2017
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Common ETF questions

There’s no doubt exchange traded funds (ETFs) are shaking up the wealth industry across the world, including Australia, and, as such have naturally attracted their fair share of friends and detractors in the process.  As a relatively new product in Australia, it’s also understandable that many investors are still learning to sort through the many claims and counter-claims made about ETF investing.  To help in this regard, I have taken the time to outline my response to some of the most common ETF questions and concerns that have been raised with me by investors over the past few years. The first part of the post deals with ETF liquidity. I’ll follow up next week with Part 2 which deals with the claims that ETFs are complex and risky and that they may be responsible for causing a bubble in sharemarkets (spoiler alert: they aren’t and they aren’t)!

Fiction: ETFs are illiquid

Questions about ETF liquidity are probably the most common questions I have received over the years.  This concern principally stems from the fact that the amount of ETF units showing for bid and offer on online share trading screens at any point in time may not seem particularly large and some ETFs don’t seem to trade that often (for example when looking at daily value of units traded on share tables and in the newspaper).

The misconception arises, however, because these widely viewed measures of “on-screen” liquidity – which measure the ready availability of buyers and sellers in the market – are really only relevant in the case of securities with fixed supply, such as listed investment companies and individual stocks.  In the case of ETFs, these measures are less relevant as they don’t capture the far deeper levels of “off-screen” liquidity available – as ETF market makers effectively stand ready to buy or sell much larger quantities (i.e. adjust supply) at prices very close to net-asset value (NAV).

The detailed mechanics behind this process are more fully explained here and here  but suffice to say the main take-away for investors is that the liquidity of an ETF goes significantly beyond ‘on-screen’ liquidity and should be at least as much as the liquidity available in the underlying holdings (so, for example, in our Nasdaq 100 ETF, the underlying liquidity of the shares making up the Nasdsaq 100 Index). As such, it should usually be possible to buy and sell sufficient quantities of an ETF at prices quite close to NAV through the trading day – irrespective of the amount currently on offer or the amount traded in recent days.  A tell-tale sign of good underlying liquidity for an ETF are quite tight bid-offer spreads and prices trading reasonably close to NAV over time.

Of course, it is true that a growing band of relatively niche ETFs are springing up across global markets, and the underlying liquidity of the assets they hold may not be very high (e.g. small gold exploration stocks).  But this is a challenge specific to these particular ETFs, rather than ETFs in general. As always, it’s a case of buyer beware.

Fiction: ETF liquidity will be withdrawn in times of crisis

A related concern is that while market makers may be ready to buy or sell ETFs during normal trading times, they may retreat to the sidelines in times of crisis.  In other words, the concern from investors is that, just when they need it most, liquidity could simply evaporate. The truth is that there is no reason to think that liquidity of ETFs during such crises should be any worse than liquidity in other investments (such as shares and managed funds).

The first point to note is that shares and managed funds may behave abnormally in abnormal times – it is unfair to single out ETFs.  A lack of buyers in times of crisis, for example, can cause the price of individual shares to fall- until such time as reluctant buyers are drawn into the market. Unlisted managed funds may also experience a surge in investor redemptions – which can and has caused many funds in the past to sell their holdings at bargain-basement prices or even halt redemptions for unitholders altogether.

In the case of ETFs, there is no reason to suggest that, during a crisis, the ETF market-makers would “disappear from the screens”. It is important to note that these players are contractually appointed by the ETF issuer to provide market-maker services and have no motivation to “flee the scene” if the going gets tough. This is because market-makers are compensated by the volume of trading they do, and are typically indifferent to market movements. It is important to understand that market-makers benefit from increased levels of trading activity. As it is typically the case that trading activity rises during crisis events, market makers are, in many ways, more incentivised than ever to remain on the screen during these times.

Of course, if the market price of underlying securities drops during a market crisis, this will be reflected in an ETF’s NAV – but this is the nature of the ETF’s exposure to the market, not the ETF vehicle per se.

Stay tuned next week for Part 2 of “ETFs: Sorting fact from fiction”

14 Comments

  1. Geoff Miller  |  July 12, 2017

    I would appreciate a clear explanation as to why HVST ETF shares have fallen so dramatically over the past 12 months compared to the market. Is it the selection and trading of the individual fund stocks or the basic HVST strategy, and what are the future prospects of recovery? It would be helpful to have some ongoing and explicit commentary so that holders of ETFs can have confidence or information to base their investment decisions, rather than theoretical analyses. Thank you. (I am a major and worried investor in HVST and YMAX).

    1. Ilan Israelstam  |  July 15, 2017

      Hi Geoff,
      Thanks for this. We have sent a response to your email

      1. Malcolm Flavel  |  July 20, 2017

        Hi IIan,
        I too have an investment in HVST and have similar concerns. I would appreciate reading the explanation provided to Geoff.

        1. Ilan Israelstam  |  July 24, 2017

          Sure we will send you this response

      2. Mike Nordstrom  |  July 23, 2017

        I am also a large investor in HVST and have the same concerns about the poor price performance of HVST recently, as outlined by Geoff Miller.

        1. Ilan Israelstam  |  July 24, 2017

          Sure – we will send you a response

  2. Chris  |  July 12, 2017

    The biggest problem that I have is that some of these ‘new’ ETFs are not actually physical holders of the underlying stocks, they are purely based on derivatives and swaps (synthetic ETFs).

    I invest in physical ETFs, not synthetic for this reason. Also, there are too many ‘fad’ ETFs trying to be ‘the ETF of everythingness’ to everyone, e.g. High Yield Growth Sustainable Dividend Leverage Index ETF, which seems to tick all the impossible boxes of a high yield, high growth investment. I don’t get it, but I get (perfectly) sticking my money into the ASX300 or the S&P500.

    To me, synthetics are just that, because combined with leverage on these instruments (which traditionally, derivatives are), not to mention any leverage that the holder of the ETF has themselves, it is a recipe for disaster to me.

    Some of the indices that they are supposed to be over as well, I’ve never heard of them (e.g. Russell Australian Value Index or Nasdaq Consumer Technology Association Cybersecurity Index) outside of the ‘traditional’ indices such as the S&P500 or the FTSE100.

    Therefore, I don’t trust these synthetic ones because it seems like any old rubbishy index has been made up to stick them into, and if the provider fails (or refuses to honour their side of the counterparty trade), I’m left holding a potentially useless derivative (a bet on an index) rather than an actual physical share in the form of the underlying stock.

    1. Ilan Israelstam  |  July 15, 2017

      Hi Chris,
      Actually there are only 3 ETFs in Australia that are synthetic (this will actually be dealt with in my post next week!). None of the new ones you are talking about are synthetic and all own the underlying assets directly. As I will also argue next week, even those three synthetic ETFs are 100% cash backed and thus certainly do have some backing beyond the derivative. Stay tuned!

  3. Paul Gates  |  July 12, 2017

    David…. There seems to be an increasing amount of interest in ETF’s as a good vehicle for investing in a group of stocks within a market.
    However, experience shows that the returns on ETF’s are generally similar and maybe marginally better than investing in the most common stocks.
    To me getting greater levels of return come in careful stock selection based on knowledge, value and a view as to future performance. This I prefer to ETF’s.
    How do you answer this?

    1. Ilan Israelstam  |  July 15, 2017

      Hi Paul,
      It is very important to note that the vast majority of ETFs do not purport to offer anything more than exposure to the basket of shares it is trying to track. In this respect they are not ‘alpha’ generating vehicles but access vehicles giving investors a simple way to instantly diversify exposures or get access to a particular asset class, strategy or international market.

      That said, ETFs can certainly be used tactically by investors who are wishing to generate alpha in their portfolios. This can include for example tilting portfolios to a particular segment or region or investing in a theme that they believe is going to outperform for structural reasons (eg such as cybersecurity or technology for example).

      In addition, there are now funds that offer innovative indexing techniques (such as our smart-beta QOZ fund) that has shown historically to outperform simple benchmark indices.

      Hope that helps

  4. Ric Bartlett  |  July 17, 2017

    Hi David,
    Thanks for the informative article, as i am looking to invest via ETF’s. The lack of buyers were a concern prior to your article.
    I’m not sure if you have addressed the liquidity question for Aus ETF’s in the light of the US “flash crash”Aug. 24, 2015, where they called trading halts. I assumed they had the background market makers as well. Would you care to comment. Cheers from someone that want to be near the exit!

    1. David Bassanese  |  July 17, 2017

      Hi Ric,

      The main issue with the flash crash was not ETFs per se, but rather market disruption in the E-mini futures market which led to a large drop in futures prices (in turn due to computer program selling gone awry). In the intra-day mayhem, liquidity in the physical stock market dried up (traders in stocks disappeared) and prices dropped which in turn caused the NAV of ETFs to fall and bid-offer spreads to widen. But the big issue is many investors selling ETFs with market orders (i.e. no price limit) intra-day which naturally led to bad prices for them .. some way below NAV if their market order was larger than the maximum units market makers have on the bid at the best prevailing price. All this highlights that few instrument offer much protection in market dislocations, and investors are warned not to panic and sell at any price – shares, LICs, ETF or other managed funds.

  5. Ric Bartlett  |  July 17, 2017

    Hi David..again,
    I’m curious as to what processes BetaShares has in place for very sharp drop in the EFT’s underlying assets. If there is a rush to the exit and price discovery goes out the door. Does the market maker keep offering a buy price for the desperate sellers? The “fear” mongers on the net are talking about a large drop like 1987, and I’m curious how the EFT’s will really behave? Cheers Ric

    1. David Bassanese  |  July 17, 2017

      Hi Ric

      Thanks for your interest. In short, the answer is yes. Unlike for individual stocks and LICs, ETTs have market makers contractually required to keep offering units for sale or purchase in all market conditions. Obviously this won’t stop the ETF’s NAV (around which bid-offer prices are set) falling if the share prices of individual stocks decline and it is likely that bid-offer spreads may widen in times of high intra-day volatility due to the risks/costs faced by market makers in hedging their positions through other markets. That said, these spreads will be more contained the higher the liquidity of the underlying securities in the ETF (eg large cap stocks vs small mining exploration stocks). In all, most ETFs (especially those holding very liquid underlying securities) should offer at least as much liquidity – if not more – as other listed investment options in times of market crisis. Hope this helps.

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