Exchange traded funds (ETFs) are touted for their many attributes, including trading like a single stock and their ability to diversify a portfolio. Are you getting as much out of them as you could be when you make trades?
ETFs have the ability to trade intraday, so the price at which they’re bought and sold can deviate from their net asset value (NAV). Esko Mickels for Morningstar says that ETFs have a secondary source of liquidity: designated brokers (also known as “authorized participants”) who are allowed to exchange the underlying basket for units with the fund company. This mechanism limits the impact of large orders, but it also puts the liquidity of the fund in the hands of its underlying investments.
Here are 10 tips for trading ETFs that could help you get the most out of them:
- 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.
- 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.
- Limit orders: Use these to define the price you’re willing to pay, thereby limiting your market impact. Read more on limit orders here.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
For more stories about ETF information, visit our ETF 101 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.