Top 5 Financial Advisor Questions About ETFs

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Amid this year’s market volatility and our frequent discussions with financial advisors about the particular benefits of ETFs, we thought we would share the most frequently asked questions from recent months.

1. What steps should I take to ensure I’ll get a good fill on an ETF trade?
There are steps a financial advisor can take to increase the chances of receiving best execution on an ETF trade…

• Take note of the ETF’s bid/ask level. If the difference between the bid and ask is small – a few cents or basis points – that’s the first sign that you may get a good fill.
• Compare the number of shares you intend to trade vs the number of shares being offered at the most competitive bid/asks. While this information isn’t always easily available, your firm’s trading system may provide this view into the depth of the book. For example, if you’re trading 500 shares, and the best bid/ask is offered up to 1,000 shares, you’re in a position to get a good fill. Even if you trade a share quantity far below the offered shares at the first layer of liquidity, it’s still best to use a limit order trade, rather than a market order trade, so you know your fill won’t be any worse than the limit level.
• Lastly, when trading a sizable number of shares above those offered in the first layer of the ETF’s book, consider the liquidity of the underlying securities in the desired ETF. If you’re considering a basic large-cap stock ETF, for example, the underlyings are likely quite liquid, and a market maker can probably offer to buy or sell them at an even more competitive price than the on-screen bid and ask.

In this case, we would urge you to consult with your firm’s ETF trading desk to request a two-sided price for the shares of interest, from three market makers. Putting the trade out to bid to a few market makers will ensure you get the most competitive price. You can also speak with an asset manager’s ETF specialists (such as those of us here at Natixis) to walk you through any or all of the above.

2. Why are ETFs generally more tax-efficient than mutual funds?
ETFs’ superior tax efficiency is due to their unique creation/redemption process. ETFs create and eliminate shares through a primary market creation/redemption process via an Authorized Participant (AP), typically a large financial firm. New ETF shares are created by an AP who transfers shares of a desired security into the ETF and receives new ETF shares in return. Conversely, to reduce the number of ETF shares, the ETF transfers out (in-kind) shares of securities to the AP, in exchange for ETF shares, which it eliminates. Transferring shares of the ETF out in-kind eliminates the need for the ETF to realize what could be meaningful gains on those securities. Thus the tax efficiency… in the form of a tax deferral. The end investor, however, is ultimately forced to pay appropriate taxes on any price appreciation that occurs when selling ETF shares in the secondary market.

Mutual funds do not create and eliminate shares in this manner. When redeeming shares, the mutual fund sells enough securities from the fund to acquire sufficient cash to cover the redemption. This forced sale often creates a taxable event for the end investor in that calendar year.

3. How do a thinly traded ETF and a thinly traded stock differ when it comes to execution risk?
A thinly traded ETF is generally more liquid than a thinly traded stock. The difference is that an ETF consists of underlying securities, each with its unique liquidity. Market makers of a thinly traded stock are bound by the stock’s current shares outstanding as a source of liquidity. In contrast, a market maker of a thinly traded ETF can examine the underlying holdings and realize they can acquire these securities in the open market to deliver to the ETF in the primary market, in exchange for newly created shares of the ETF for their buyer. The clear operational difference between mutual funds and ETFs accounts for ETFs’ superior liquidity.

4. What prompts financial advisors to use mutual funds vs ETFs vs Separately Managed Accounts (SMAs)?
Mutual funds remain a key vehicle type used in the defined contribution market, since many of the largest recordkeepers administering these plans do not permit ETFs. Mutual funds also tend to be relatively popular in other retirement accounts since tax efficiency is not needed. Outside of the defined contribution and general retirement market, we’ve seen increasing interest from financial advisors to use either SMAs or ETFs. The key reason is tax efficiency. Both SMAs and ETFs are very tax-efficient, with SMAs allowing for security-by-security tax loss harvesting, while ETFs use the previously mentioned creation/redemption process to generate tax efficiency. Some financial advisors prefer ETFs for their ease of trading and no minimum investment requirements, while others choose SMAs for the ability to customize, carefully manage tax loss harvesting, and transport accumulated losses to other accounts.

5. Are ETFs available on most broker-dealers and custodial platforms?
Yes, most ETFs are fully available on competitive broker-dealer platforms. This is particularly true for custodial platforms such as Fidelity, Schwab, Pershing and Envestnet. While wirehouses and independent platforms do offer many ETFs, such firms have recently become more stringent about adding them, frequently requiring a minimum Asset under Management level, average daily volume, and interest expressed by a financial advisor before adding them to their platforms.

We hope these insights are helpful. Please reach out to our ETF team to discuss these and any other questions.