If you want to buy ETFs, you need a securities account. The costs are lowest with direct banks and online brokers. However, investors must carry out their purchases and sales independently on the computer. Branch bank customers have it convenient. If you want to buy ETF, simply tell your bank advisor about your order. He then carries out the transaction on the exchange. After a few days, the customer receives an invoice in the mail. But this service is expensive. Investors can save hundreds of dollars per year if they switch to an inexpensive direct bank or an online broker.
The disadvantage: With these providers, customers have to trade their securities independently. That scares some off.
BUY ETF – WHAT GOES ON BEHIND THE SCENES
ETFs are seen as transparent, flexible and inexpensive. However, on the behind the scenes in stock exchange trading with index funds is difficult for private investors to understand. Some of them pay excessive prices when they buy ETFs. And those who sell during crashes often have to accept particularly high discounts on the fair value of the fund. Most investors assume that the market price of an ETF share corresponds to the market value of the bonds or stocks in index fund in the respective mapping ratio. In technical terminology, this objectively determinable price is called the net asset value (NAV). The NAV is the fair price for an ETF share.
ETFS OFTEN TRADE BELOW OR ABOVE THEIR FAIR VALUE
But ETF prices on the stock exchange are often well above or below the NAV. The less liquid the securities in the index that the ETF tracks, the greater the deviations of the market price from the net asset value. With very high uncertainty on the stock exchanges and sharply falling prices, such as in 2008 after the bankruptcy of Lehman Brothers, the prices for some ETFs can fall by more than 10 percent below their net asset value. This was the case with ETFs on poorly liquid high-yield bonds. Surprisingly, this ETF were several billion dollars in assets under management comparatively large, were traded frequently and had narrow spreads between bid and ask prices. Even in normal stock market phases, when price fluctuations are at an average level, the stock exchange prices of ETFs, which reflect the performance of less liquid asset classes, can fluctuate by 1 to 2 percent around their net asset value.
THIS IS HOW THE TRADING MECHANISM BEHIND ETF WORKS
The reason why there are discrepancies between the exchange price of an ETF and its fundamental value as measured by the NAV is due to the obviously imperfect trading mechanism, which is actually supposed to ensure that both prices largely match.
ETF providers conclude contracts with large trading companies, which are thereby legitimized as so-called Authorized Participants (APs). These are the only trading participants to have direct access to the ETF. Only they can return shares in the ETF at the current NAV and receive the corresponding portfolio of securities that the ETF represents. Or they get newly created shares in an ETF and have to deliver securities in return. The shortage or increase of the ETF shares available for trading is intended to ensure that their market price moves close to the net asset value.
BUYING ETFS: THE LIMITS OF ARBITRAGE
If security prices fall sharply, the hedging costs for authorized participants increase. For example, it is more expensive to borrow securities to sell short because the demand increases. The prices for put options are also climbing. The higher hedging costs are reflected on the stock exchange in higher differences between the sales and purchase prices of ETF units. At the same time, however, arbitrage business is also becoming less attractive. The result: The exchange price of an ETF is more strongly influenced by the supply and demand for ETF shares. If there are relatively more sellers than buyers, the exchange prices for ETFs slide below their net asset value.
WHEN THE ARBITRAGE MECHANISM FAILS
Due to the increasing popularity of ETFs and their growing influence on the international financial markets, supervisory authorities are now also grappling with possible worst-case scenarios. The Irish central bank, for example, is investigating in a discussion paper what would happen if all Authorized Participants withdraw from so-called primary market trading in an ETF. This would be conceivable in extreme market situations in which arbitrage transactions would be too risky, for example because the securities that ETFs track would no longer be traded and lack of market prices would cause disorientation.