Would you buy ETF or individual stocks ?
In the US, investors should buy mutual funds with long-term records of management teams that generate alpha relative to beta. Alpha is the excess return relative to what would be expected given its Beta, which is the relative risk. An ideal is high Alpha with low Beta. There are other things to consider.
In Canada, fund expenses are higher than in the US because funds must register and pay fees in each province, whereas in the US, they are subject only to national requirements from the SEC and FINRA.
I would never invest in an ETF, since you don't own the underlying stocks. ETFs are very complex and not understood by most retail investors.
Market makers and authorized participants make huge profits on trades that investors do not see. The Bid/Ask spread may represent an overvaluation relative to the actual spread of the stocks it participates in, but does not own. In the US, the 2010 "flash crash" showed how a lack of liquidity led to some ETFs' bids being set at $0.01, with ETF sellers eventually being rescued by the SEC/FINRA, which eventually blocked trades.
The Extreme ETF Drop: Because automated liquidity providers (market makers) withdrew or posted nominal "stub quotes" (bidding as low as 0.01), many ETFs plummeted to absurdly low values. About 70% of all securities with trades canceled by the SEC were ETFs.
In a typical market crash, ETFs can be more negatively affected by liquidity constraints than the underlying stocks they track. Retail investors are more likely to panic and sell during a major market decline, as they did in the 2010 flash crash, than institutional investors such as mutual funds.
The 2010 Flash Crash - ETF "Reset": Regulators from the SEC and major exchanges stepped in after the crash and canceled trades in ETFs that deviated by more than 10% from their transaction prices prior to the erroneous plunge. Consequently, the true "market reset" decline that stuck for the SPY [S&P500] ETF at its absolute worst trading moment was approximately 18% to 20% off its pre-drop value.
The Huge Profits in ETFs/Costs to Investors
Authorized Participants hold a legal contract with the ETF issuer. They are the only entities that can create or redeem ETF shares directly with the fund in large blocks (usually 25,000 to 50,000 shares) known as "creation units." Market Makers are liquidity providers on the stock exchange. They constantly quote buy (bid) and sell (ask) prices so that everyday investors can trade ETF shares instantly.
Market Makers profit directly from the bid-ask spread. This is their primary source of income. They buy ETF shares from investors at the lower bid price and sell them to other investors at the higher ask price, pocketing the tiny difference millions of times a day.
Authorized Participants profit from arbitrage; they profit when the ETF share price drifts away from the value of its underlying stocks. If the ETF becomes overpriced, the AP buys the cheaper underlying stocks, exchanges them with the issuer for new ETF shares, sells those shares for a premium, and pockets the difference.
For Nerds like me, details of the May 10, 2010, "flash crash" when many ETFs went to $0.01 Bid
I was watching the May 6, 2010, market crisis live on CNBC Market Watch. The anchors were perplexed as to why they were not getting quotes or why they were getting quotes at $0.01 in their market reports. "What happened?" was their confused response as millions wondered. Power failure? Enemy attack on the system?
From the SEC 104 page report "May 6, 2010 Market Event Findings," I have highlighted below the most meaningful parts of the SEC's very long technical analysis, especially regarding ETFs.
In our Preliminary Report, we noted that many of the securities experiencing the most severe price dislocations on May 6 [2010] were equity-based ETFs. A large majority of ETF market makers paused their market-making for extended periods starting at about 2:45 p.m. on May 6. We believe this is one of the reasons equity-based ETFs were disproportionately affected by the extreme price volatilities of that afternoon.
Anecdotally, market makers in ETFs reported that ETFs trade differently from individual securities, often resulting in more concentrated liquidity on exchange order books. Specifically, they considered ETFs a “professional’s market,” where the depth of the book is more limited than for individual stocks, and there are few, if any, resting retail orders far from the mid-quote. Sell pressure that overwhelms immediately available near-inside liquidity is less likely to be “caught” by resting orders farther from the mid-quote in an ETF.
Some equity exchanges automatically generate stub quotes, and a subset requires their market makers to use such a mechanism to ensure compliance with continuous two-sided quoting rules. Some allow for flexibility in specifying how auto-generated quotes cascade upwards or downwards as market prices move, though floors of 1 penny or 1/100th of a penny on the bid side.
One reason that auto-generated quotes are implemented is to ensure market makers can “technically” meet their continuous two-sided quoting obligations even if they have temporarily disconnected from the exchange. A trade priced at $0.01 may have been the result of an exchange-generated stub quote or an active market maker quoting at that same level.
Others reported that they sent orders seeking to hit stub quotes to prevent the piling up of orders in their internal systems.
Though the type of volatility experienced that day is very unusual, even more extraordinary was the fact that over 20,000 trades representing 5.5 million shares were executed at prices more than 60% away from their 2:40 p.m. value. These trades were subsequently broken by the exchanges and FINRA under their clearly erroneous rules because they were executed at clearly unrealistic prices under severe market conditions. Almost two-thirds of shares in canceled trades were executed at prices below $1.00.
On May 6, both market and limit orders were executed against stub quotes. Many trades that originated with retail customers as stop-loss or market orders were converted to limit orders by internalizers before being routed to the exchanges for execution. If that limit order could not be filled because the market continued to fall, then the internalizer set a new lower limit price and resubmitted the order, following the price down and eventually reaching unrealistically low bids. Given that internalizers generally process and route retail trading interest, this suggests that at least half of all broken trade share volume was due to retail customer sell orders. [Retail smaller investor orders vs typically large institutional trades.]
The data also provides important information on the extent to which declarations of self-help by Nasdaq and BATS against NYSE Arca may have exacerbated the issues on May 6. For example, a large [$4.1 billion sell order] by a market maker specialized in ETFs on NYSE Arca. The internalizer had routed approximately 2,400 sell orders to NYSE Arca for about 1.7 million shares.
The next section will discuss NYSE Arca, which "is a fully electronic securities exchange owned by the Intercontinental Exchange (ICE) that specializes in the listing and trading of Exchange-Traded Products (ETPs), including ETFs and ETNs. It holds the largest market share for ETF trading volume globally." Source NYSE]
Nasdaq declared self-help against NYSE Arca at 2:35:59 p.m., and Nasdaq OMX BX declared self-help against NYSE Arca at 2:38:40 p.m. The Nasdaq declaration was revoked at 3:01:09 p.m., and the Nasdaq OMX BX exception was revoked at 3:01:55 p.m. Data indicate that for a subset of securities, NYSE Arca repeatedly did not respond to orders from these exchanges within one second. Consistent with Rule 611, Nasdaq and Nasdaq OMX BX notified NYSE Arca directly concerning their use of the self-help exception. They also publicly disclosed their Self-Help Declarations on their website. As a result, many market participants were aware of the Self-Help Declarations soon after they were made.
[The "self-help" rule:] “trading centers should be entitled to bypass another trading center’s quotations if it repeatedly fails to respond within one second to incoming orders attempting to access its protected quotations,...the declarer of self-help must adopt objective parameters for use of the exception, must immediately notify the exchange that is the subject of the self-help declaration." [The report notes that in normal times, trades and quotes are typically aggregated from various systems in generally less than 10 milliseconds.]
The fact that a single market maker [ETF] on NYSE Arca accounted for so many broken trades suggests that it was one of the last providers of liquidity for those securities in that market. Other market makers had either stopped quoting or were quoting at even lower prices, demonstrating the extent to which liquidity had virtually evaporated.
We obtained order audit trail files from several sources, including NYSE, NYSE Amex, NYSE Arca, Nasdaq and BATS, each containing detailed data on orders received, modified, canceled, and executed. In total, this data contained 5.3 billion records.
On September 10, 2010, the SEC approved new rules submitted by the national exchanges and FINRA that clarify the process for breaking erroneous trades.
