Jules Staniewicz: The recent postings on the precious and base metals ETFs dealt with the specifics in the markets, but contained in the article (if you look REALLY hard) were some signs of the dangers of ETF investing. I am specifically calling them dangers, as opposed to risks, because most investors automatically think of risks as market risk or volatility. There are dangers often (though not exclusively) encountered in ETF investing that may not be obvious at first glance. By recognizing these potential dangers, an investor can often take the steps to avoid the danger, or at least to know they are there if they cannot be completely avoided.
The first danger is illiquidity. This was mentioned by way of talking about the daily volume of the respective ETFs. However, there are more subtle nuances to this as well. Below is a table of the bid-ask spread for the ETFs mentioned in the metals articles. This is just a random mid-morning sampling from last week, and does not give a size of the bid or offer.
In the case of (NYSE:GLD), the tight one cent spread shows clearly that there is no liquidity concern in this ETF. Similarly (NYSE:IAU), (NYSE:SLV) and (NYSE:JJC) had the narrowest of spreads. As one drops down the liquidity scale the spread rises to almost 1% of the price in the case of (NYSE:JJN) and (NYSE:JJT). This is the direct cost of illiquidity, increased transaction costs, over and above whatever commission one pays. The main way to temper this risk is the use of limit orders, rather than market orders, on less liquid ETFs. This does not eliminate the spread, but it may prevent the spread from widening against you if circumstances change. Again, the table was a sampling on a non-descript morning. If market conditions deteriorate, these spreads will get even wider, and this effect will be especially pronounced in the spreads which were wide in normal times.
One other subtlety worth pointing out is in the difference of GLD and IAU. Note that even though the spreads are the same in terms of being one cent between the bid and ask, but on a percentage basis, it is quite a different story. If one is using this as a short-term trading vehicle, GLD is far preferable, since the same penny spread is one-tenth the cost.
Another danger is the potential danger of the timing of an investment. While the metals markets are open before the stock market opens in the morning, other ETFs that deal in agricultural markets trade before the agricultural markets open. Between 9:30 eastern (when the stock market opens) and 10:30 eastern (when the agricultural markets re-open), ETFs based on agricultural markets do not have active quotes for the underlying instruments in the ETF. During such time, bid-ask spreads will likely expand as a protection mechanism for those making markets in these ETFs.
Further, make sure you know what you’re buying. As an example, look at (NYSE:DBP) and (NYSE:GLTR). Both of these are broad precious metals market baskets. However, DBP is gold and silver in a roughly 80/20 ratio. GLTR is gold, silver, platinum and palladium in one and the ratio is 53/37/6/4. The danger is not that one is a superior blend to the other, rather that the blend is quite different. Different blends can and likely will produce different results. Investors should be sure they understand the composition of the underlying. It is quite a different thing to get a 4-to-1 ratio of gold rather than just about an even split with a broader basket.
For now, take away these few items:
1) Stick to the most liquid vehicles possible for what you are trying to do.
2) Use limit orders for less liquid vehicles.
3) Be aware of what the underlying composition of the ETF you are trading.
4) Be mindful of the dynamics of the underlying market and trade when all markets are open at the same time.
Jules Staniewicz has worked in the financial industry for 30 years. He has been the co-head of alternative investments for a major Wall Street brokerage firm and worked for 15 years with a multi-billion alternative investment manager.
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