No matter what’s going on in the markets, there is still one constant everyone can rely on: exchange traded funds (ETFs). They offer the diversification of mutual funds, generally without the high price, along with the liquidity of stocks. The real key to using ETFs successfully, however, is knowing how to trade them.

If you’re considering incorporating ETFs into your practice, you may want to bone up on a few important rules for success, and then we’ll dig deeper into these points:

  • Understand Them. You should be willing and able to keep up with the technical details of ETFs and their market volatility. Understand how ETFs work and know how you can best use them in your portfolio.
  • Know Your Orders. Use the right kind of trade order. Market orders are placed at market prices and you can’t control the price at which the order is filled. Always use limit orders. You may not be guaranteed execution of your trade, but you are guaranteed a price, so there are no surprises.
  • Costs. Pay attention to trading costs. Beyond commissions and expense ratios, watch the bid/ask spread. Any more than five or 10 cents, and you should be careful. If you’re placing a large order, there are different trading options available for advisors.
  • Know the iNAV. The intraday value is meant to give investors an idea of the relationship between a basket of securities represented by the ETF and the share price of the ETF itself. The iNAV is calculated every 15 seconds, so it’s the most current picture of the value of a fund’s holdings you can get. If the iNAV is below the bid/ask, buying is generally not a good idea; if it’s above, it is. This information can be found in a variety of places: on Google Finance, it can be found by typing “.IV” after a ticker; on Yahoo, by typing “-IV” after a ticker.

The Details

Although exchange traded funds (ETFs) provide an easy way to gain broad exposure to different market sectors, not all of them are created equal. ETFs that track the same sector, related indexes, and even the same index will vary in performance because of a number of different factors.

Some funds differ in their index composition and methodology. One ETF may weight stocks by revenue rather than market value, while another looks at trailing stock performance amongst other factors.

Other things to look for include:

  • The expense ratio will have a direct impact on fund returns and vary from fund to fund. Always check to make sure you’re getting the best deal and that you know what you’re paying.
  • The fund size can have a direct impact on trading costs because volume helps keep trading costs low.
  • Finally, the composition of funds can also impact both performance and risk. An equal-weight fund will perform differently than a fund with 50% of its weight given to the top five holdings.

Market Makers

Market makers are a little-seen segment of the market, but they’re there, working hard to keep the markets and ETFs running efficiently. A market maker is a broker-dealer firm that assumes the risk of holding a certain number of shares of a security in order to ease the process of trading the security. The true market makers and proprietary traders are looking for the fastest way to hedge trades, create units and maximize ETF trading capabilities. Some other facts about market makers:

  • When an ETF launches, the lead market maker will create the first units, delivering the contents of a product’s basket in exchange for shares of the ETF.
  • Next, the lead market maker will generally sell shares of the ETF to buyers and hedge the sales by buying an equivalent number of underlying shares.
  • They are given a bona fide hedging exemption (meaning, they’re exempt from limits on speculative positions) to keep the markets moving in a fair and orderly way.
  • Lead market makers must stand ready to both buy and sell their assigned products on a continuous basis; lead market makers also serve as a sort of “investor” for the ETF industry.

ETF market makers instantly lock in their profits through arbitrage, rather than risking exposure on either side as they are attempting to hedge. This type of transaction goes on with all ETFs, and can happen with both liquid and illiquid products.

Market Orders vs. Limit Orders

Market orders are orders to buy or sell at the current market price, as opposed to limit orders. Although placing a market order guarantees your order will go through, the price you pay may not ultimately be the price quoted. Throw in a highly volatile market and you could lose a lot of money. It’s wise to use limit orders when buying or selling. This ensures that you never pay more than what you specify and transfers the control of the trade back into your hands.

However, there is also a caveat with limit orders. Lack of liquidity has been an issue with some of the newer ETFs coming out. These ETFs are not as heavily traded or do not have the robust volumes that some of the more established ETFs have. There may be problems with “price improvement” and those who use limit orders. With spreads up to 4 cents, one might want to use a limit order, but an investor may miss execution if the price goes up.

In the end, it is important to keep in mind the trading volume and liquidity of an ETF when purchasing a large order. This is especially true of some of the newer thinly traded ETFs.

Bid/Ask Spread