October 30, 2009 at 12:00 pm by Tom Lydon
Many who visit this site may already be well aware of what exchange traded funds (ETFs) are. But as evidenced by all the new money pouring into them, many investors are just starting out on their journey with ETFs. It’s worth revisiting the basics, whether you’re a newbie or an old hand.
Exchange traded funds (ETFs) are baskets of securities with an underlying index that trade all day on an exchange like a stock. They’ve been around since 1993. The first ETF, the SPDRS (NYSEArca: SPY), tracked the S&P 500. The strategy of indexing is not new, however. Barclay’s created it in 1971.
Some of the advantages of ETFs include:
- You always know what you’re buying, because they replicate indexes. The holdings of those indexes are easily available and posted daily.
- ETFs offer safety in numbers. They have more diversification because they’re a basket of stocks rather than one individual stock.
- Their performance can be easily tracked.
- ETFs tend to have lower expenses and fees because they passively track indexes. There are no additional fees to pay to a fund manager. The average fee for a mutual fund is about 1.6%, while for a large-cap growth ETF it’s about 0.15%.
- They’re tax efficient because investors rarely generate capital gains.
It’s easy to trade ETFs. Esko Mickels for Morningstar compiled a list of tips all ETF investors should have under their caps, and we tossed in a few bonus ones of our own, as well:
1. Timing the trade: Be careful buying and selling ETF during the first and last 30 minutes of the day. An ETF’s volatility is highest at those times and wide spreads are more common.
2. Exercise caution on volatile days: Volatile days in the market can throw an ETF’s underlying value off of its bid-ask spread, so tread with caution.
3. Limit orders: Use these to define the price you’re willing to pay, thereby limiting your market impact. Read more on limit orders here.
4. Select ETFs with high 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. These also remain closer to their NAV.
5. Trade during an open underlying market: If you are investing in overseas markets, it is best to trade the correlating ETF when the overseas market is open. This avoids any uncertainty.
6. Use a stop-loss: 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. A trailing stop-loss ratchets up the stop-loss price as your ETF’s price increases. Read more on stop losses here.
7. Watch the fees: Consider broker fees for every transaction. The more trades you do, the more you are paying in fees, taking away from your gains.
8. Leveraged ETFs: Pay attention to thee funds daily, as they can move in radical directions. These also require re-balancing often, meaning more fees to rack up. More on leveraged and inverse ETFs can be found here.
9. 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.
10. Distribution date: Most ETFs are very tax efficient because their turnover is low. There’s the potential that investors holding some ETFs on the day of record can trigger a capital gains event. More information on taxes and ETFs can be found here.
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