Exchange-traded funds (ETFs) are structured much like mutual funds, because they hold an underlying basket of investments in which investors have proportional ownership stakes. But when it comes to buying and selling ETFs, the strategies involved sometimes make them more akin to stocks. Specifically, ETFs are similar to stocks because you incur brokerage fees when you buy and sell. These expenses can add up quickly if you trade frequently, especially if you have an account with high fees.
With that in mind, here are some suggestions for placing ETF orders that we think can improve your returns. Less experienced investors are encouraged to seek the assistance of their broker and/or adviser.
1. Avoid placing orders near the open and close
In the morning, ETF prices may adjust to the difference (premium or discount) between the previous day's closing price and the ETF’s net asset value (NAV). This can result in ETF prices moving in the opposite direction of their underlying holdings. These gaps may persist for some funds and tend to be larger for funds that track foreign markets.
In the morning, adjustments are also occurring to an ETF's underlying stocks as they open. Approaching the close of trading, market makers (working for the designated broker) often begin to take down positions and hedge their books (especially in funds that track foreign indices). These factors increase an ETF's volatility, often resulting in rapid price changes and wide spreads between the bid and the ask price. A good practice is to avoid placing orders during the first and last 30 minutes of trading.
2. Use caution during volatile days
During days of heightened volatility the underlying stocks' movements can temporarily throw an ETF's underlying value off its bid-ask spread (the difference between the highest buyer's bid price and lowest seller's ask price). As well, the bid-ask spread will likely widen.
3. Use limit orders for best execution
When there is a wide bid-ask spread, placing a limit order and letting the market come to you may help. Limit orders define the price you're willing to pay, thereby limiting your market impact.
Market orders, which execute at the best available price at the moment, are fine for ETFs with tight spreads and good liquidity relative to your order size. The risk with using a limit order is that your order doesn't get filled and you miss out on the ETF's move.
4. Select ETFs with good liquidity
If possible, select funds with tight bid-ask spreads and good trading volume. While high volume doesn't necessarily equal liquidity, it implies that a limit order for a few hundred shares near the current mid-market price should be filled quickly. Large orders, which are more concerned with price impacts, generally benefit from the market makers' ability to keep prices close to the NAV and execute large block trades.
5. Trade while the underlying market is open
If you are investing in an ETF that holds foreign securities, such as US or emerging market equities, you should consider investing only while the underlying market is open, if possible. It is also important to note that many commodities markets don't have the same hours as the regular stock market. For instance, the Chicago Board of Trade's grain contracts don't open until 10:30 EST and they close at 14:15 EST (16:30 – 20:15 GMT), which means they’re not open during LSE trading hours. By restricting your trades to mutual hours, you are less likely to pay up for the uncertainty.
6. Consider using a stop-loss order
A stop-loss is an automatic sell order that is triggered when an ETF's price falls to a predetermined threshold. The most common stop-loss is set at a specific price, which allows you to limit losses. Another valuable type of stop-loss is a trailing stop-loss, which ratchets up the stop-loss price as your ETF's price increases. This way, you can let your winners run while virtually locking in your gains.
A common risk with this strategy is that the ETF's price movements can trigger a sale, and then the ETF could subsequently move back in your favour, causing you to miss the upside. This is one of the reasons why setting a stop-loss is more art than science. Set it too narrow and you risk exiting your position prematurely. Set it too wide and you risk taking on a greater loss. The use of stop-losses is a contentious issue. Generally, stop-loss orders are better suited to short-term momentum plays, rather than long-term investments.
7. Pay attention to transaction costs
One of the fastest ways to give money away is by paying high brokerage fees. Consider how much you are paying for each leg of your transaction - round-trip transaction costs are what matter. These costs become particularly important if you're frequently investing a small amount of money. If that's the case, an index mutual fund may be a better option if you can find a similar one to the ETF you want to buy. Brokerage costs vary widely, based on the level of service, convenience, trading frequency and the size of your account, amongst other factors.
8. Be careful when using leveraged ETFs
Leveraged ETF products exacerbate price movements, making it even more important that you receive good execution. Since they are designed to track daily movements of an underlying index or futures contract, holding them for longer periods will result in deviations from the underlying benchmark. If you want to maintain your exposure, you'll have to rebalance often, which is costly.
9. Consider the number of market makers
Market makers working for the designated brokers add liquidity and help keep the bid-ask near the ETF's underlying value, so having more is generally desirable. To determine who's making a market for an ETF, either ask the fund company or watch the broker I.D. (if you receive level-two quotes).
The original version of this article was published July 2009 on Morningstar.ca.
