Some investors gloss over the "exchange-traded" part of the exchange-traded fund, failing to understand or appreciate those two words and the implications of investing in a fund that trades like a stock.
It is hard to fault them, as many of the largest ETFs trade at tight spreads in very narrow bands around their net asset values, and through most market conditions. But not all ETFs are created equal, and nor are all market environments.
The mechanisms that underpin the ETF ecosystem have experienced hiccups of varying magnitude, ranging from 2010's "flash crash" and the early morning meltdown witnessed on August 24 2015, to more sporadic episodes of lesser scope and impact. These events have served as painful reminders of why investors should exercise caution when using ETFs.
It is always a good time to brush up on what constitutes good hygiene when transacting ETFs. Here, I provide five tips on how to best trade them.
1) Use Limit Orders
If I had to provide just one tip, this would be it. Use limit orders when trading ETFs.
(Aside: What is a limit order? According to the US SEC, a limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.)
Investors tend to use market orders in instances where time is of the essence and price is of secondary importance.
(Aside: What is a market order? As the US SEC explains, a market order is an order to buy or sell a security immediately. This type of order guarantees that the order will be executed, but does not guarantee the execution price. A market order generally will execute at or near the current bid price for a sell order, or ask price for a buy order.)
Investors using market orders want to execute their entire order as soon as possible. For very large, very liquid ETFs that trade contemporaneously with their underlying securities, market orders will likely result in fast execution at a good price. But many exchange-traded products are smaller and less liquid, and may trade out of sync with their constituent securities.
In all cases, using limit orders is good practice. Limit orders will ensure favorable execution from a price perspective. A buy limit order will fetch the buyer a price less than or equal to the limit price, while a sell limit order will transact at a price greater than or equal to the limit price. What is the potential cost of using limit orders?
Well, time and incomplete execution. That is, it may take longer for a limit order to be filled than a market order, and when that time comes it might not be completely filled. These costs need to be weighed against the cost of being exploited by an opportunistic market maker looking to pick off market orders in thinly-traded ETFs.
2) Trade When the Underlying Market Is Open
If you are trading an ETF that invests in securities that trade in markets outside of the EU, or Canada, or the United States, it's best to trade the associated ETF when its constituents are actively changing hands in their home market.
During these overlapping trading hours, it is easier for market makers to keep the ETF's price in line with its NAV, as the stocks in its portfolio are still being bought and sold in the local market. Once local markets close, market makers rely on the fluctuations of the open markets as a guide in setting prices, an inherently less-reliable touchstone.
Of course, some markets that are tracked by ETFs may have zero overlap with your local trading hours, like Japan ETFs for US investors, for example. In such circumstances, consider tip 1 before trading.
3) Don't Trade Near the Open – or The Close, For That Matter
It's best to avoid trading ETFs just after the opening bell: ETFs may take a while to "wake up" in the morning. For a variety of reasons, it takes some time for all of the securities in their portfolios to begin trading. Before all of an ETF's constituents are trading, market makers may demand wider spreads as compensation for price uncertainty.
It's also a good idea to avoid trading ETFs as the closing bell approaches. As the market winds down toward day's end, many market makers step back from the markets to limit their risk headed into the close. At this point, spreads tend to widen as there are fewer actors actively quoting prices.
In light of these considerations, it makes sense to wait about 30 minutes after the opening bell to trade an ETF and to avoid trading during the half hour leading into the market's close.
4) If You're Making a Big Trade, Phone a Friend
For investors looking to execute a large trade in an ETF, it makes sense to engage the help of a professional. There is no hard-and-fast definition as to what qualifies as a large trade.
General rules of thumb would place any trade that accounts for 20% of an ETF's average daily volume or more than 1% of its assets under management as fitting this description. In these cases, investors can potentially save themselves substantial execution costs at the expense of spending some time on the phone with a representative of an ETF provider's capital markets team and/or a market maker.
Ben Johnson, CFA, is director of global exchange-traded fund research for Morningstar
