- Because exchange-traded funds (ETFs) offer more liquidity than mutual funds, they are not only popular investment vehicles but also easy to access when cash is needed.
- The composition of an ETF and the trading volume of the individual securities that make up the ETF are the two most important elements that determine its liquidity.
- Secondary factors that influence an ETF’s liquidity, on the other hand, include its trading volume and the investment climate.
Focus
Bond exchange-traded funds (ETFs) have expanded steadily over the last decade, managing more than $1.2 trillion as of early 2021. We show that the bond market’s peculiarities lead to different arbitrage mechanics for bond ETFs than for traditionally studied equity ETFs. Bond ETF baskets (the collection of assets used to produce or redeem ETF shares) contain only a small percentage of holdings, which we call “fractional baskets.” This fact calls into question the widely held belief that baskets represent holdings, and it has significant ramifications for the ETF arbitrage process. Fractional baskets, we believe, are a feature of ETFs that contain illiquid assets because they operate as a buffer between the ETF market and the underlying bond market. We also demonstrate how authorized participants can help ETFs avoid fire sales.
Contribution
Our paper contributes in three ways. First, we present a new method for determining baskets. Second, we show that baskets only account for a small portion of holdings, distinguishing bond ETFs from stock ETFs in terms of arbitrage. We show how fractional baskets can result in long-term ETF premia and discounts. This conclusion shows that the volatility impacts of arbitrage trading in equity ETFs, which have been reported in prior research, may be mitigated in bond ETFs. Third, we propose that fractional baskets for illiquid bond ETFs can be advantageous during times of stress by allowing approved participants to act as a buffer and avoid fire sales.
Findings
Several new facts are documented. For ETFs that contain corporate bonds, we find that around 10% of assets are in creation baskets and 20% are in redemption baskets. This is in sharp contrast to ETFs that invest in stocks and bonds, where ETF baskets account for nearly all of the assets. Second, the baskets of corporate bond ETFs have a high turnover rate. Third, compared to holdings, creation (redemption) baskets have longer (shorter) durations and lower (larger) bid-ask spreads. Finally, we propose a model that suggests ETFs may be more effective than mutual funds in managing illiquid assets.
What are the risks associated with ETFs?
They are, without a doubt, less expensive than mutual funds. They are, without a doubt, more tax efficient than mutual funds. Sure, they’re transparent, well-structured, and well-designed in general.
But what about the dangers? There are dozens of them. But, for the sake of this post, let’s focus on the big ten.
1) The Risk of the Market
Market risk is the single most significant risk with ETFs. The stock market is rising (hurray!). They’re also on their way down (boo!). ETFs are nothing more than a wrapper for the investments they hold. So if you buy an S&P 500 ETF and the S&P 500 drops 50%, no amount of cheapness, tax efficiency, or transparency will help you.
The “judge a book by its cover” risk is the second most common danger we observe in ETFs. With over 1,800 ETFs on the market today, investors have a lot of options in whichever sector they want to invest in. For example, in previous years, the difference between the best-performing “biotech” ETF and the worst-performing “biotech” ETF was over 18%.
Why? One ETF invests in next-generation genomics businesses that aim to cure cancer, while the other invests in tool companies that support the life sciences industry. Are they both biotech? Yes. However, they have diverse meanings for different people.
3) The Risk of Exotic Exposure
ETFs have done an incredible job of opening up new markets, from traditional equities and bonds to commodities, currencies, options techniques, and more. Is it, however, a good idea to have ready access to these complex strategies? Not if you haven’t completed your assignment.
Do you want an example? Is the U.S. Oil ETF (USO | A-100) a crude oil price tracker? No, not quite. Over the course of a year, does the ProShares Ultra QQQ ETF (QLD), a 2X leveraged ETF, deliver 200 percent of the return of its benchmark index? No, it doesn’t work that way.
4) Tax Liability
On the tax front, the “exotic” risk is present. The SPDR Gold Trust (GLD | A-100) invests in gold bars and closely tracks the price of gold. Will you pay the long-term capital gains tax rate on GLD if you buy it and hold it for a year?
If it were a stock, you would. Even though you can buy and sell GLD like a stock, you’re taxed on the gold bars it holds. Gold bars are also considered a “collectible” by the Internal Revenue Service. That implies you’ll be taxed at a rate of 28% no matter how long you keep them.
5) The Risk of a Counterparty
For the most part, ETFs are free of counterparty risk. Although fearmongers like to instill worry of securities-lending activities within ETFs, this is mainly unfounded: securities-lending schemes are typically over-collateralized and exceedingly secure.
When it comes to ETNs, counterparty risk is extremely important. “What Is An ETN?” explains what an ETN is. ETNs are basically debt notes that are backed by a bank. You’re out of luck if the bank goes out of business.
6) The Threat of a Shutdown
There are a lot of popular ETFs out there, but there are also a lot of unloved ETFs. Approximately 100 of these unpopular ETFs are delisted each year.
The failure of an exchange-traded fund (ETF) is not the end of the world. The fund is liquidated, and shareholders receive cash payments. But it’s not enjoyable. During the liquidation process, the ETF will frequently realize capital gains, which it will distribute to the owners of record. There will also be transaction charges, inconsistencies in tracking, and a variety of other issues. One fund company even had the audacity to charge shareholders for the legal fees associated with the fund’s closure (this is rare, but it did happen).
7) The Risk of a Hot-New-Thing
In an ETF, how does liquidity work?
Liquidity is one of the most misunderstood elements of ETFs. The amount of units traded on an exchange plus the liquidity of the individual assets in the ETF’s portfolio make up ETF liquidity. ETFs are open-ended, which means that units can be created or redeemed at any time in response to investor demand. Market makers, who buy and sell ETFs throughout the day, oversee this process.
How do you determine an ETF’s liquidity?
The bid-offer spread is the most evident sign of an ETF’s liquidity. The spread is the difference between the price you’d pay to buy an ETF and the price you’d get if you sold it. It’s a cost of doing business (just like exchanging foreign currency at the airport).
What is an ETF?
An ETF is a fund that holds a basket of securities that reflect an underlying index. The stocks owned in the fund are not chosen at random. The fund is set up to mirror the composition of the underlying index.
An ETF is linked to this index and will own proportional stakes in all of the index’s 500 or so stocks.
The fund is meant to track the S&P 500’s movements. With this type of ETF, the investor is essentially buying the S&P 500’s performance.
ETFs, unlike mutual funds, trade like stocks. They even trade on stock markets around the world. ETF shares are purchased in the same way that individual company stock is. As a result, brokerage houses usually charge the same commission on ETF purchases as they do on stock purchases.
For example, a broker might charge a $7 commission for both buying and selling stocks and ETFs.
You do not own the securities held in an ETF when you buy shares in it. Those are the ETF’s own assets. The securities are only indirectly owned by investors.
Any interest or dividends paid by the underlying securities are distributed to shareholders in proportion. If the fund is ever liquidated, they are also entitled to a proportional residual value.
ETFs are more liquid than mutual funds since they trade like stocks and on stock exchanges. They can be bought and sold in the same way that stocks can, without the need to go through many fund families and their individual redemption processes.
“Passive” Management
ETFs are considered passively managed because they are index-based. Unlike mutual funds, which buy and sell securities whenever the fund manager sees fit, ETFs only exchange stocks when the underlying index’s composition changes.
Because this doesn’t happen very often, the fund sees very little buying and selling. Only then will the ETF execute trades if ABC Company is removed from the index and replaced by XYZ Corporation. They’ll do that to keep the index’s settings up to date.
During the course of a typical year, this leaves relatively little commerce. In effect, the fund constructs a portfolio that closely resembles the underlying index, and only makes adjustments when the index does.
As a result, ETFs don’t create much in the way of capital gains. When they do, it’s by chance.
For example, if the fund sells ABC Company at a greater price than when it was purchased, the fund will either make a capital gain or a capital loss. However, that is a rather uncommon occurrence.
Because they are linked to an underlying index, the value of each ETF share grows and decreases in lockstep with the index. ETFs can also act like equities in this sense. An ETF’s gains and losses are reflected in the fund’s price. You can hold an ETF until it doubles or triples in value, then sell it to realize your profit, just like a stock.
Tax Implications of Passive Management
The passive management of ETFs has a number of advantages. Capital gains are common in actively managed funds, which include many mutual funds. Long-term capital gains have lower rates and are capped at 0%, 15%, and 20% in 2018. (Most taxpayers will be in the 0% tax bracket.)
Short-term capital gains, on the other hand, are taxed at ordinary income rates. These can be as high as 37%. Any gain achieved on a stock or security purchased less than a year ago is considered a short-term capital gain.
Actively managed funds frequently generate both short-term and long-term capital gains.
This is why mutual funds frequently report both long-term and short-term capital gains, as well as dividends, when filing their taxes. Dividends are usually the principal source of taxable revenue for ETFs.
Changes in the underlying index may result in a minor amount of long-term capital gains. However, because ETFs do not actively trade, short-term capital gains are rare.
As a result, ETF focuses mostly on tax avoidance. The ETF generates capital gains rather than the individual assets within the fund. However, those gains aren’t realized until you sell your ETF position. You’ll only have a capital gain after that, and it’ll almost probably be long-term. As a result, it will be able to take advantage of the lower long-term capital gains tax rates.
As a result, if you hold an ETF for 20 or 30 years, you won’t see any significant financial gains until you sell it. That will continue to be the case for tax payments in the future. This is similar to a tax-deferred retirement account, except it also applies to taxable accounts.
ETF Fees
- Fees for distribution. These are costs associated with marketing and selling mutual fund shares. It covers things like paying brokers and others who sell fund shares, as well as advertising, prospectus printing and mailing, and sales literature printing and distribution. Each year, this component of the fee is capped at 0.75 percent of the fund balance.
The combined sum of the two portions of the 12b-1 fee is 1.00 percent, which is the maximum amount that can be charged lawfully. Many ETFs, on the other hand, have substantially lower 12b-1 costs.
Assume you have a choice between two ETFs that track the S&P 500 index. One has 1.00 percent 12b-1 fees, while the other has 0.50 percent. That is a 0.50 percent difference. It’s also the amount that each fund’s net return on investment will be reduced by.
Both funds are anticipated to generate a nominal annual return of 10%. However, after subtracting 12b-1 costs, the first fund has a net return of 9%, while the second has a net return of 9.5 percent.
If you invest $10,000 in the first fund for 30 years, your account will increase to $132,684 at a net annual return of 9%. Your account will grow to $152,200 if you invest $10,000 in the second fund for 30 years at a net yearly return of 9.5 percent.
Although a half percent every year may not seem like much, it adds up to over $20,000 over 30 years. The moral of the story is that 12b-1 fees are important. Look for the lowest-cost ETFs.
Broker Commissions
These costs are imposed by the financial brokerages that offer ETFs, not by the ETFs themselves. It’s normally the same fee that’s charged for purchasing and selling individual equities.
Regardless of the financial amount of the fund purchased, the most prominent brokerage firms charge between $5 and $10 every trade.
Broker commissions will be a minimal expense unless you want to actively trade ETFs.
The Benefits of ETFs
Tax liability is minimal. Tax ramifications are minimal from one year to the next since they create few long-term capital gains and almost no short-term capital gains. Even the dividends paid are frequently eligible dividends subject to long-term capital gains taxation. Dividends will be tax-free for the vast majority of taxpayers.
The markets are being followed. If you’re looking for a way to mimic the market’s performance, ETFs are the way to go. They will not outperform the market, but neither will they underperform it. As a result, they are an ideal asset allocation in a well-balanced portfolio.
What’s more, since they track so many indices, you can find an ETF for just about any investment segment.
Large-cap stocks, mid-cap stocks, small-cap stocks, international stocks, emerging market equities, and numerous sector segments such as healthcare, high-tech, and housing are all examples of this.
Non-stock assets, such as bonds, government securities, gold and other commodities, and real estate, are also available as ETFs.
Fees are low. They can be bought and sold with no transaction fees – other than broker charges – because they don’t charge load fees.
And, while 12b-1 fees are annual and inconvenient, they can be extremely cheap on some funds. A huge percentage of ETFs have fees that are less than 0.20 percent. Those are the ones you should take into consideration.
How and Where to Invest in ETFs
Purchasing an ETF is analogous to purchasing a stock. You can buy an ETF in shares or for a set sum of money. The funds usually have no investment minimums, making them especially appealing to new and small investors.
Large financial brokerage businesses such as Ally Invest, E*TRADE, and TD Ameritrade offer ETFs for purchase. Each has a large selection of ETFs and inexpensive trading charges.
In the portfolios they build for you, robo-advisors often use ETFs.
Because asset allocation is a big part of their Modern Portfolio Theory, ETFs are a great approach to get the diversification they want.
A typical robo-advisor will build your portfolio out of six to twelve different ETFs. Each one will represent a different type of asset. Foreign and domestic stocks, emerging market stocks, domestic and international bonds, and commodities and/or real estate are frequently included.
Betterment, Wealthfront, and Ally Invest are three of the most popular robo-advisors. They’re ideal for investing in ETFs, especially if you have no idea which funds you want to hold.
Is there a bubble in ETFs?
As we continue to live in the digital age, when knowledge is abundant and accessible, an increasing number of people are beginning to invest. Not only is it more appealing to invest these days due to the abundance of information, but it is also easier due to a market that continues to rise. For example, if you put $1,000 into the S&P 500 in 2019, you’d end up with $1,3041, and you could do it in January and not touch the money again until the following year. This exemplifies the effectiveness of passive investing.
More individuals are realizing how simple it is to invest in an index like the S&P 500, which can instantly diversify your portfolio, as evidenced by the fact that over half of all money in the market is invested passively.
2 The overall amount of money invested in ETFs (exchange-traded funds) is currently $5.3 trillion3, and analysts at Bank of America project that by 2030, the total amount of money invested in ETFs will be $50 trillion. 3 Whether or not there is an ETF bubble, which we can now discuss, the truth remains that the rise in passive investment will exacerbate the consequences of the next financial crisis.
Are exchange-traded funds (ETFs) safer than stocks?
Although this is a frequent misperception, this is not the case. Although ETFs are baskets of equities or assets, they are normally adequately diversified. However, some ETFs invest in high-risk sectors or use higher-risk tactics, such as leverage. A leveraged ETF tracking commodity prices, for example, may be more volatile and thus riskier than a stable blue chip.
What is the significance of ETF liquidity?
Greater liquidity, or the capacity to sell an asset for cash quickly and effectively, benefits investors and traders in any investment. Investors who own non-liquid ETFs may have difficulty selling them at the price they want or in the time period required. Furthermore, if an ETF invests in illiquid stocks or uses leverage, the fund’s market price may fall far below its net asset value (NAV).
Is the Voyager spaceship an ETF?
There are a lot of financial applications vying for your attention, and Spaceship Voyager might or might not be the perfect fit for you. Before you make your final selection, consider the following options:
- Stake. Allows you to invest in equities in the United States that you choose. Brokerage costs are not charged on trades, but other fees may apply.
- Superhero. For a flat $5 cost, you can trade in over 2,500 ASX-listed items, starting with a $100 investment.
- SelfWealth. For a flat charge of $9.50 per trade, you can invest in firms listed on the ASX, NASDAQ, and NYSE.
- Pearler. Long-term investors will benefit from this online trading platform. It helps with investing goal-setting and provides automated investment top-ups. Fees for transactions begin at $9.50.
- Stockspot. In a similar way to Spaceship, you choose a portfolio to invest in (in this case, based on your risk tolerance) and the investment is automated. Monthly fees start at $5.50 and only invest in ETFs (Exchange Traded Funds).
- CMC Markets is a company that specializes in financial markets. Commission-free stock trading in the United States, the United Kingdom, and Canada. For Australian trades, there is a low cost of $11 or 0.1 percent, which decreases if you make more deals in a month. Fees for trading in other nations are exorbitant.