An exchange traded fund is exactly what its name implies – it is a fund that is traded on an exchange. Since the funds are traded like stocks, investors should follow some basic guidelines to optimally execute trades.
For instance, ETF investors should use limit orders to have better control over trades as this order would place a specific price at which you want to buy or sell a fund.
“So, instead of just saying ‘market,’ where you could just get whatever the next offer is or whatever that price will get filled at, with a limit order, you’re specifying, I will pay no more than this or I will sell it at no less than this price,” Street One Financial President Scott Freeze said in a Morningstar report.
However, if a trader is only moving a small position in a highly liquid fund, such as the SPDR S&P 500 (NYSEArca: SPY), limit orders are not typically required since the bid/ask spreads are very tight, or only a penny apart.
“Limit orders really don’t come into play until you’re talking about more esoteric, thinly traded ETFs,” Freeze added. “Maybe if it has a wider spread, say $0.05 or more. If it’s something that trades 400 shares a day, 2,000 shares a day, then you might want to start looking at limit orders, just so that you don’t have any adverse price impact.” [Bid/Ask Spreads]
Moreover, investors should get in the habit of comparing the ETF’s price to its net asset value as big price deviations would translate to indirect costs. Freeze suggests looking at the indicative value, or IIV, which is regularly updated to check on U.S. domestic equity related funds. However, the IIV on commodity, fixed-income or foreign ETFs could be a little stale as these funds track international markets on different timezones. Consequently, these ETFs could see a premium or discount to the NAV. [True Liquidity]
If an advisor wants to fill a large bulk order, he or she should remain patient and fill out the order over a period in a way that would create minimal price impact, especially in a thinly traded ETF. [Creation & Redemptions]
“You can buy your entire chunk at one time, but you’re going to need to go through the creation and redemption process … where you are going to have to work with the trading firm to be able to do that,” Freeze said.
For more information on trading ETFs, visit our ETF 101 category.
Max Chen contributed to this article.