In response to Adam Bold and Stacey Schreft’s article from Monday, May 10th, titled How ETFs Have Been Oversold When It Comes To Flexibility, Lower Costs, and Tax Efficiency, I feel compelled to reveal some counterpoints that those experienced in ETF trade execution and liquidity will see as obvious, but most average investors, advisors, and ETF industry naysayers may have simply dismissed in the past because of their dearth of knowledge about ETFs.

First, the timing of the article is all-too-coincidental. I question whether this was on ice and simply waiting for a “black eye” day [see editor’s response to this concern at the bottom of the article] for the ETF industry to take place, as it did on May 6th, 2010, before running. (We in fact published a piece on Morningstar ETFs relevant to ETF Trading Lessons learned shortly after May 6th as well, and it can be accessed here.

One of the points made in the Bold/Schreft article centers around ETFs having a lack of pricing transparency, and somehow that intraday pricing is worse than than the decades-old 4 p.m. NAV that mutual funds calculate as the entry/exit price for investors. Anyone who has spent time on a trading floor, or has been involved in trading in any way during the course of his or her career, will almost universally admit that 4 p.m. may be the absolute worst time to optimize one’s trading. If there is any doubt about this, simply ask someone who is even peripherally involved in trading.

The authors speak of “manipulation” in the pricing of ETFs. This is a very dangerous word to use in the context of ETFs without providing some backup evidence. None is supplied in the article.

Manipulation? If so, it’s common

Of course, “marking” the close with large buy and sell imbalances in individual securities to meet shareholder redemptions or inflows in the mutual fund industry has been going on for decades, and this may be considered manipulation in some circles.

In fact, each day on the NYSE, the public buy and sell imbalances are published, and these almost universally reflect buy and sell orders that have been harvested over the day by mutual funds so they can execute on the close, for the 4 p.m. NAVs. What happens, each and every day, is that individual securities are overbought and or oversold en masse, so as to complete the “market on close” or “MOC” orders for mutual funds, at seemingly arbitrary supply/demand prices, for the 4 p.m. NAV.

Traders often take the “other side” of mutual fund MOC orders because the temporary buy and sell imbalances are executed in the market at prices, often on heavy volume, that reflect liquidity gaps, and are simply not reflective of the short term fair values of the stocks, and therefore it is often not a surprise when the stock immediately trades higher or lower in the after hours session than the 4 p.m. price.

“Funny” closing prices can occur on any given day in individual stocks, and often are the results of sloppily executed market on close orders generated from mutual funds that need to buy or sell certain securities into the closing bell, and often the next day in the marketplace, these securities regress back to their fair price.

So, for the individual investor, you often buy and sell at inopportune times, and have absolutely zero control over your entry or exit into a position because you are simply relegated to the 4 p.m. closing NAV prices that mutual funds deliver.

Gaming by big firms skew security prices

Additionally, since Wall Street knows how mutual funds trade going into the bell, “gaming” often occurs by big trading firms that skew the individual security prices even more so into gaps in liquidity due to this information slippage. It is true that an ETF can trade at a discount or premium to NAV, but simple research into the daily facts that are supplied on the ETF issuers’ websites will show anyone who cares to look, that these discounts and premiums are largely statistically insignificant. They are simply portrayed as a “device of fear” in the context of this article.

On this same point, is a 4 p.m. NAV of a mutual fund that has no discount or premium that was arrived upon by reckless buying and selling going into the bell in typical MOC fashion, somehow more beneficial to the end investor than an intraday ETF price that is a fraction of a percent off of the ETF’s NAV? Is the mutual fund’s 4 p.m. NAV really a “true” NAV?

One line in the article particularly perturbs me because it is not based on factual information, but simply popular, uninformed banter.

It says, “the market price of ETFs could be subject to manipulation, given their often limited liquidity.”

What does this mean exactly? Manipulation is, first off, illegal. Are the authors suggesting that traders and/or the ETF issuers themselves are complicit in manipulating the prices of ETFs to the detriment of investors? This is an extremely strong accusation, and one that every ETF issuer, every trading firm, and every ETF investor should think about. Is the author saying that May 6th, 2010, was “manipulation?”

Smart trading desks would not sell into panicked activity

Also, what does “limited liquidity” refer to, exactly? It’s hard to make a sweeping statement about the entire ETF industry using those two words. I have a simple answer. May 6th was a result of electronic quoting systems slowing up, and nearly freezing en masse (the same electronic quoting systems that mutual fund managers rely on to trade their securities, on the same stock exchanges that mutual funds execute their orders on), and many investors and many trading desks that are not well versed in ETFs simply panicking because they do not understand ETFs nor how they are priced. ETF centric trading desks evaluate ETFs on a “basket” or “index” level, and just because the ETF may have appeared to have traded at say 10 cents on May 6th, if the underlying constituents were trading at prices that would imply the ETF should be valued at say $39, a smart trading desk would not be selling into the panicked activity.

Furthermore, the industry has been preaching to investors for years never to use market orders on a normal trading day, yet people still do, and when extraneous events occur as they did on May 6th, market orders were executed at outrageously low prices because there were no “real” markets displayed in many ETFs for a small gap of time. The same goes for stop loss orders that became market orders. Investors who used “stop limits” had nothing to worry about, except maybe that they did not execute because the market gapped away from them. But this will happen from time to time even in normal market conditions, and it simply forces the investor to reevaluate their exit points. If investors and advisors better understood the mechanics of ETF trading would not have been penalized through terrible trade execution during that session. Those investors and advisors would have wisely allowed a seasoned ETF desk to execute their orders as opposed to just sending their order-flow to a venue of convenience that may or may not be experienced in ETFs.

With an ETF, the investor or advisor can select when they want to act on an instinct and monetize this. Perhaps the market opens down one morning and the investor feels this is a buying opportunity. The investor can purchase shares and then benefit from possible appreciation over the course of that day. In 2008 and 2009, there were countless examples of days in the market where the market traded at certain levels for hours on end, and then made a radical move, in the complete opposite direction of the general trend over the course of the day going into the last hour or final minutes of trading. These are severe and costly opportunity costs for mutual fund investors that advisors and pundits simply ignore instead of trying to quantify.

Hundreds of basis points

Recall the market bottoming in March 2009, when an investor who wanted to purchase into the Dow’s weakness when it briefly fell below 7,000 was forced to “wait until the 4 p.m. NAV” and watch hundreds of basis points that should have been realized to an astute trading entry point evaporate due to the inherent pricing limitations of mutual funds. With an ETF, this would never have been an issue.

How waiting until the market close on a day when the writing may be on the wall and all signs tell the advisor it is time to cut losses and run, is more beneficial than exiting at or near a predetermined exit price is somehow better for the investor, I will never know. This section of the column by Mr. Bold and Ms. Schreft seems to argue that offering a product that has trading flexibility is worse than a product that has no intraday trading flexibility, but instead is pinned to the 4 p.m. closing price so that trading firms can predictably trade against the MOC orderflow routinely in a way that is detrimental to long-term returns of shareholders.

I also want to refute with the “Low Cost?” section. I will not disagree that the commission on ETF trades is something to factor in to your overall decision. But the intraday trading flexibility will pay for these commissions quickly and many times over because the investor doesn’t give away gains that otherwise would have been realized if it were not for he limitations of waiting for the 4 p.m. NAV prices on a mutual fund. If an investor wants to buy into early morning market weakness during a session where he feels the market will rally into the close, and he is right, this may amount to hundreds of basis points in excess return realized for the portfolio as opposed to trading at the seemingly random 4 p.m. NAV price. In very volatile markets, many entry and exit points present themselves during each trading day, and they cannot be monetized, even for the longer term investor, due to the limitations of the mutual fund structure.

Mutual fund companies get into the ETF game

ETFs remain supreme vehicles to mutual funds, and if this were at all in question, established mutual fund players such as Vanguard, Pimco, T Rowe Price, Legg Mason, Eaton Vance, John Hancock, Dreyfus, and a growing list of additional managers would not be in the game, or looking to get into the game.

These traditional mutual fund companies are launching “actively managed ETFs” at a quickening pace, which will eventually change the thinking of those who are still in the frame of mind that ETFs are “passive indexes.”

There is room for improvement no doubt, including education on trading, which the ETF issuers provide day in and day out. May 6th may happen again, but those ETF users who use an ETF trading desk and pledge to themselves that they will never use a market order or a straight stop order (instead using stop limits), will not be in the position of trading at suboptimal prices like the rest of the crowd.

Elizabeth’s note: This column was written in response to one by Adam Bold and Stacey Schreft, as you read. Paul Weisbruch suggests that either the authors or the editors held it as we waited for a black-eye day. We deserve neither such blame nor such credit. I had a lunch with Adam in April, and after hearing his thoughts on ETFs, asked him to submit a piece. We had it for about a week in advance of its publication — and did chose to run it after the events of May 6. That wasn’t because we wanted to give ETFs a black eye, but because we thought readers would be more interested so soon after the high-level discussion of ETFs that occurred because of May 6.