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Exchange Traded Funds (ETFs)

The MCI trading strategies use Exchange Traded Funds (ETF’s) as our investment vechicle to trade. If you are relatively new to trading, you probably have heard of them, but may not be completely familiar with them and how they work. If that’s the case, then read on…

What is an ETF?

An ETF is similar to a Mutual Fund, in that it is a pooled investment vehicle which can consist of stocks, bonds, commodities, and / or other assets. However, a key distinguishing feature of an ETF is that it trades throughout the day on an exchange (thus the term “exchange-traded”) at a market-determined price, just like a stock does. In contrast, mutual funds are traded at a single price based on the Net Asset Value (NAV) which is calculated at the end of each trading day. Another key difference between ETFs and mutual funds is that ETFs can be bought and sold by investors and their financial advisors directly through a brokerage firm, whereas mutual fund trades are transacted directly with the fund company, (although the orders are usually placed through a brokerage firm).

ETF Liquidity

Unlike individual stocks, whose liquidity is directly related to their traded volume on stock exchanges, ETFs get most of their liquidity from sources other than their trading activity on exchanges. As a result, an ETF’s average daily volume (ADV) is not an accurate gauge of its liquidity. In fact, many ETFs can be traded in amounts that greatly exceed their ADV without having a major impact on their prices.The main determinant of an ETF’s liquidity is the liquidity of its underlying securities. An ETF that consists of highly liquid securities with substantial traded volume will have a high degree of liquidity as well. An ETF that tracks widely-followed indices, such as the ETF’s we use in our strategies, have very high liquidity.

ETF Costs

Like mutual funds, ETFs incur expenses in their day-to-day operations that are passed on to investors. Investors also incur certain other costs when trading ETFs. These include:

  • Operating expenses – The fees that an ETF charges to cover its expenses and for managing the fund are expressed as a percentage of fund assets, known as the management expense ratio (MER). Trading expenses and commissions paid by the ETF, as well as withholding taxes on foreign income, are summarized in a separate category called the trading expense ratio (TER).

  • Broker commissions – Investors who buy and sell ETFs usually do so through a broker, who may charge a flat transaction fee as commission.

  • Bid-ask spread – Investors also have to contend with the bid-ask spread for ETF shares. As noted earlier, the bid-ask spread will be tight for ETFs that are heavily traded or whose underlying securities have ample liquidity.

Why does MCI use ETFs?

Our strategies rely on our trading signals to get us in and out of the market at the most opportune times. This requires the use of an investment vehicle that can be traded without restriction. Many mutual funds have minimum holding period or other trading restrictions which make them incompatible with most of our strategies. This is because our strategies will not often hold positions longer than a few days to a few weeks.

Because of the daily Net-Asset-Value (NAV) pricing, mutual funds are more suited to a “buy and hold” type of strategy, and can certainly be a useful component of a core position within a portfolio. However, they are not well suited for use with our strategies.

Article Credits : Exchange-Traded Funds: Background https://www.investopedia.com/university/exchange-traded-fund

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