Every genre within Wall Street has its lingo. In venture capital world, for example, it’s all about seed investment, term sheets and the harvest period. In other circles, the verbiage used to describe aspects of a particular category or type of investment is unique to them.
Since the first U.S. exchange-traded fund was listed in 1993, ETFs have defined their own culture and language. And over the years, the language ETF use has changed. At the very least, financial advisors who allocate money to ETFs on behalf of clients should be familiarized with ETF lingo. Let’s examine some of these words.
Bid/Ask Spread
Like with individual stocks, ETFs have bid/ask spreads. The bid denotes the price someone is willing to buy a fund at whereas the ask is the price someone is willing to sell at. ETF sellers receive the lower price (the bid), while buyers pay the higher price (the ask).
Bid/ask spreads for high-volume ETFs like the SPDR S&P 500 ETF (SPY) are minimal, thereby reducing the frictional costs associated with buying and selling. Thinly traded ETFs tend to have higher bid/ask spreads, thereby increasing an ETF trader’s cost. Also, it’s possible for ETFs that hold very liquid stocks to suffer from wide bid/ask spread due to depressed trading volume in the fund.
While it’s a good habit to stick with ETFs that have narrow bid/ask spreads, funds that are leveraged or track niche asset classes will generally have higher spreads. Morningstar.com expresses ETF bid/ask spreads in percentage terms, similar to an expense ratio. Looking at bid/ask spreads in this manner provides a better understanding of an ETF’s actual trading cost.
Factor Investing
ETFs that use factor investing try to exploit attributes that are associated with higher historical returns such as small caps, momentum, low volatility, quality, value and yield. The origins of factor investing are rooted in academic research by Eugene Fama at the University of Chicago and Kenneth French at Dartmouth College.
Although factor and smart beta investing are sometimes used interchangeably within the ETF marketplace, Rob Arnott, founder and chairman of Newport Beach, Calif.-based Research Affiliates, argues they are different. Because factor investing starts by using a market capitalization weight and later adds a factor tilt, Arnott claims it isn’t the same as smart beta.
Smart Beta
Towers Watson, a London-based consulting firm, coined the term “smart beta” in 2007. The wordplay was used to describe an indexing strategy that weighted stocks by fundamental measures like price-to-earnings ratio and book value rather than by a company’s market capitalization. The idea was to prevent an index from becoming overly influenced by companies with outsized market caps.
Prior to the invention of the smart beta moniker, the strategy was known as “fundamental indexing” and it was popularized by Rob Arnott at Research Affiliates.
iNav
Most advisors are familiar with net asset value, or NAV. It’s calculated by adding up the total value of the fund’s holdings minus the fund’s liabilitie, and then dividing that by the number of outstanding shares.
Mutual funds are bought and sold at NAV, whereas ETFs are bought and sold at intraday market prices. For that reason, the iNAV, or intraday net asset value, has become a popular way to gauge how well an ETF’s price is tracking its NAV.