How ETFs Trade Differently Than Stocks
“As individual investors, when we first learned about the ETF structure, there were some caveats that we were told we may have forgotten or chosen to ignore over years of smooth trading and steadily increasing assets under management. Usually it is safe to ignore the fact that an ETF does not trade exactly like a stock. Unlike stocks, ETFs only trade on electronic exchanges without even the potential for human specialist intervention. Usually it is safe to ignore the fact that, although they usually do, market makers are not obligated to provide quotes near net asset values, because arbitrage provides incentives to keep market prices near net asset values. It is therefore more important to use limit orders.” writes Michael Rawson, CFA (ETF Analyst for Morningstar)
Mike continues to say, “Like mutual funds, most ETFs (roughly 85% of them) are organized as Regulated Investment Companies under the Investment Company Act of 1940. When you buy an open-end mutual fund, you deal directly with the fund company, which creates new fund units for you in exchange for cash, which the fund will promptly re-deploy into securities. The fund company stands to exchange shares in the fund with investors at NAV but only at the end of day. If the fund company is unable to do this exchange (perhaps there are too many investors seeking redemptions and the fund is invested in illiquid securities), fund shareholders may be given the underlying securities in lieu of cash or the fund may be unable to immediately honor redemptions, as happened with The Reserve Fund, and may go into a forced liquidation. Because fund shareholders actually own a share of stock in the RIC, they are entitled to vote for the board of trustees, who are supposed to look out for the best interests of fund shareholders and limit any conflicts of interest with fund management.”
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