Wednesday, July 5, 2017

Are ETFs a Potential Market Liquidity Problem?

I have previously written are about market liquidity potential problems in responding to a Noah Smith article and put forth the opinion that equity ETFs are more liquid than ETNs, although a financial crisis might cause market liquidity problems when everyone is trying to sell.  I also said they are a second choice to mutual funds holding same basket of stocks, because the transaction costs can be significantly larger for ETFs although their annual fees may be less.  Now, Bank of America is questioning whether large money flows into ETFs is distorting market price-earnings(PE) and  over

estimating the true float (shares available) of S&P stocks.  Again, when everyone wants to sell in a falling market, how many will be able to sell and at what price?  In such a situation, it would be expected that the bid/ask spread could increase adding to transaction costs, particularly since ETFs would be trying to sell a basket of different equities rather than just one stock.  If there are not enough buyers for the ETF, the holders will be stuck and transact at a more unfavorable price.  Mutual fund sales will always be settled at the end of the market day at the same price and a transaction fee that is not market influenced.  Josh Brown poo-poos this as just whining that one cannot transact at the price one wants.  The point is that the price will not only be lower but the transaction costs may also be higher if one is successful in selling.

ETFs are better held in balanced portfolios that are positioned as holding portfolios consistent with the investor's age and/or ability to absorb a more than 10% market fall.  (My sell rule is to sell a stock when there is an 8% fall and the market trend is down.)  Obviously, they should be sparsely, and with particular purpose, used in portfolios of those in retirement or very near retirement.  You will not find many investment advisers telling people what I have just written. 

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