There are many nuances and rules about trading and investing in exchange traded funds (ETFs). Whether you’re an old hand at investing or a newbie, it’s always worth reviewing the basics and the do’s and don’ts of trading.
You’re eager to get started, we know. Let’s get down to business:
- Size matters, to a point. While trading volume is important, it’s not the be-all, end-all. By limiting the number of ETFs you would consider to only those with the highest trading volume, you could be missing out on dozens of worthy and interesting funds, says Paul Weisbruch for Advisor Perspectives.
- All ETFs are not created equal. The industry started out offering plain vanilla, broad-based ETFs that tracked major indexes. From there, the industry has moved on to commodity ETFs, leveraged and inverse ETFs, currency ETFs and ETFs that divvy up the markets into interesting sub-sectors. For this reason, the evaluation of ETFs has changed, and the trading volume and liquidity definitions must be redefined to suit every fund.
- Measuring liquidity in an ETF. The basic idea here is to know what the ETF invests in and what companies the index tracks. The liquidity of an ETF has everything to do with the liquidity of the underlying stocks that the ETF’s index tracks and little to do with the average daily trading volume of the ETF itself.
- Pay attention to bid/ask spreads. The price movements of an ETF’s underlying stocks determine its pricing regardless of the fund’s trading volume during a given session. Consider using a limit order when buying or selling ETFs, to ensure fair execution regardless of the bid/ask spread.
- Pricing efficiency. Trading volume is not dictating the price changes in the ETFs. The driving force is changes in the market via the underlying securities. Unlike a closed-end fund (CEF), which is driven by buyers or sellers in the market, an ETF’s value will fluctuate all day, every day regardless of volume.
- Trade execution. Always use limit orders. Sending a market order for even one of the most frequently traded ETFs will often result paying an unnecessarily high price or selling for too little relative to the ETF’s real value.
- Evaluate each ETF individually. Do not evaluate the quality of an ETF or its suitability for a portfolio based on volume alone. Evaluate each ETF on its own merits and take all the possible factors, including the bid/ask spread, the weighting of its components, the index it tracks, index methodology, total assets and more, into consideration.
The basic message is to choose ETFs wisely by educating both yourself, and where applicable, your clients. The underlying holdings that make up an ETF are just as important as the fund as a whole.
For more direction in ETF investing, look at The ETF Trend Following Playbook, as it can give you more insight and strategy education.
For more stories about trend following, visit our trend following category.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.