Should ETF Issuers Publish Trading Guides?

The ETF Knowledge Gap

The ETF industry has done an excellent job teaching investors why to own ETFs. It has spent far less time teaching investors how to trade them.

Having been involved with ETFs since I started at Susquehanna Investment Group in 1999, ETF trading has become second nature to me.

After spending nearly two decades trading ETFs and the remainder of my career in ETF capital markets, it still amazes me how little many investors, advisors, and even industry professionals understand about how ETFs actually trade.

Over the years, I have seen some truly remarkable orders, executions, and expectations. Investors expecting to buy or sell at yesterday's NAV. Advisors surprised that an international ETF trades differently when the underlying markets are closed. Investors assuming that because an ETF is highly liquid, the displayed order book should be filled with thousands of shares waiting on both sides of the market.

Some of the most memorable examples I have seen had little to do with the ETF itself and everything to do with how the order was entered.

I have seen stop limit orders entered with limit prices dollars away from the prevailing market. I have seen investors place held orders with limit prices 5% above the market, effectively instructing the broker to complete the trade regardless of changing market conditions. In one case, the execution occurred exactly as instructed, but the investor was understandably unhappy with the result.

The ETF did exactly what it was supposed to do. The order did exactly what it was instructed to do. The problem was a lack of understanding of how the order type worked.

Why ETF Trading Education Matters

That is what makes ETF education so important.

The ETF wrapper itself is one of the greatest innovations in modern investing. It provides transparency, tax efficiency, liquidity, diversification, and access to strategies that were once difficult or expensive to obtain. But like any investment vehicle, there are pitfalls. Many of those pitfalls have nothing to do with the portfolio manager or the strategy. They stem from investors not fully understanding how to trade the product.

Knowing when to use a limit order. Understanding why an international ETF may trade differently when the underlying market is closed. Recognizing that an ETF's displayed volume may have little relationship to its true liquidity. Understanding why a premium or discount may exist at a given moment. These concepts can have a meaningful impact on investor outcomes.

A New Generation of ETF Investors

Another factor that is often overlooked is the rapid influx of new entrants into the ETF ecosystem.

Today, many of the firms launching ETFs come from traditional mutual fund or hedge fund backgrounds. This is a positive development for investors because it expands access to new strategies and investment approaches. However, these firms are often bringing investor bases and distribution teams that have spent years operating in a very different environment.

In the mutual fund world, investors typically hand over a lump sum and transact at NAV. They rarely think about spreads, market makers, premiums and discounts, order types, or intraday execution. Those considerations largely remain behind the scenes.

ETFs are different. Investors now have the ability to trade throughout the day, but that additional flexibility also creates additional responsibilities. Understanding how an ETF trades can be just as important as understanding what the ETF owns.

This is not a criticism of new entrants or their investors. Every asset manager entering the ETF space goes through a learning curve. The same is true for advisors and distribution teams. In many cases, some degree of education and hand holding is necessary during the transition.

There is nothing wrong with that.

The key is recognizing that ETF education is not a one time event. It is an ongoing process. As products become more sophisticated and new investors enter the market, issuers have an opportunity to improve investor outcomes by continuing to teach not only the benefits of ETFs, but also the mechanics of trading them effectively.

The ETF Volume Misconception

Perhaps no misconception illustrates this better than the industry's obsession with ETF trading volume.

For many advisors and investors, daily trading volume remains one of the first statistics they look at when evaluating an ETF. In some cases, it becomes an anchor. If the ETF does not trade a certain number of shares per day, they immediately conclude that it is illiquid or difficult to trade.

In reality, daily volume often tells only a small part of the story.

An ETF's true liquidity is largely derived from the liquidity of its underlying holdings. A U.S. equity ETF that trades only a few thousand shares per day may still be capable of efficiently handling a much larger order because market makers can create or redeem shares using the underlying basket. Conversely, an ETF that trades substantial volume may still face liquidity challenges if the underlying securities themselves become difficult to access, value, or trade.

What the Municipal Bond Market Taught Investors

History has provided several examples of why investors should focus on underlying liquidity rather than simply looking at ETF trading volume.

The municipal bond ETF market during the COVID selloff provides one of the best examples.

Prior to the volatility, many municipal bond ETFs traded millions of shares per day and were generally viewed as highly liquid products. As stress entered the fixed income markets, spreads widened, discounts to NAV appeared, and market makers became increasingly cautious.

Some investors viewed this as a failure of the ETF structure.

In reality, many would argue the opposite.

The ETF market continued to trade while the underlying bond market became increasingly difficult to value and transact in. Rather than failing, the ETFs were helping establish price discovery during a period when the underlying securities were not changing hands frequently enough to provide reliable pricing information.

At the same time, investors often dismiss newly launched ETFs because they trade relatively little volume. Yet many of these products hold highly liquid securities that could support substantial trading activity with very little market impact through the creation and redemption process.

This highlights one of the most misunderstood aspects of ETF trading. Volume and liquidity are not the same thing.

An ETF that trades millions of shares per day can still experience liquidity challenges if its underlying holdings become difficult to value or trade. Conversely, an ETF that trades only a few thousand shares per day may be capable of handling significantly larger transactions if its underlying holdings are highly liquid.

Understanding what is inside the ETF is often far more important than simply looking at the ETF's daily trading volume.

What Every ETF Trading Guide Should Cover

Many issuers spend significant resources on portfolio construction, marketing, distribution, and product education. Yet some of the most important topics affecting investor outcomes are rarely discussed on issuer websites.

In my opinion, every ETF issuer should consider providing basic educational materials covering:

• Limit orders versus market orders
• ETF liquidity versus ETF volume
• Premiums and discounts
• International market considerations
• Opening and closing market rotations
• ETF block desks and large order execution
• Fair value adjustments and changing market conditions

These topics may seem basic to ETF professionals, but they are not basic to many investors, advisors, and distribution teams entering the ETF ecosystem for the first time.

Education Should Extend Beyond Portfolio Holdings

Perhaps it is time for more issuers to consider publishing ETF trading guides and best execution practices.

As ETFs continue to grow in complexity and attract new investors, education should not stop at what an ETF owns.

Investors should also understand how to trade it properly.

The industry has spent years educating investors on what ETFs own. Perhaps it is time to spend more effort educating investors on how ETFs trade, why they trade the way they do, and how investors can use them more effectively.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.