ETFs, or Exchange Traded Funds, are similar to a mutual fund because they invest in a basket of stocks. However, one clear advantage of ETFs is that they trade intra-day in a similar manner to stocks. When trading these positions, we can monitor intra-day prices and sell or buy at an exact price whereas mutual funds are only traded at the end of the day. This has been covered in the past and has been repeatedly flogged by Pinnacle as one of many reasons to switch our US Equity holdings to ETFs. But during a recent trade, I strategically ignored this benefit to take advantage of pricing inefficiencies in a specific security.
Like any other stock, ETFs are purchased at the bid (the price a dealer is willing to sell you a stock) and sold at the ask (the price a dealer is willing to pay for your stock). The difference between the two prices is called the spread. If a stock is actively traded then the spread is very small (typically $.01) and if a stock is thinly traded then the spread is very large. When purchasing an ETF with a large spread it is very likely that the purchase price will be way above the ETF Net Asset Value (NAV). The NAV is the weighted price of the basket of stocks being bought. So what is a trader to do?
In order to avoid the large spread difference, and get a better buy price for our clients, I called the creator of the ETF being purchased and asked to buy through a process called ‘creation’. Basically, you tell the creator of the ETF a quantity to purchase, and they create new shares at the NAV. It is a very simple process but it does take away the ability to intra-day trade. The creator will fill the new order but it is for the NAV at the close of the business day very similar to a mutual fund. This was a small price to pay for the thinly traded ETF when the eventual savings to our clients were very large.
