Exchange traded funds are just what their appellation implies: funds that trade on an exchange. Consequently, potential ETF investors should understand how best to utilize the investment tool.
While ETFs help investors easily and efficiently access many corners of the markets, people should still exercise caution when buying and selling ETF shares, writes Ben Johnson, director of global ETF research for Morningstar.
Specifically, investors should consider some factors when trading ETFs: Use limit orders, invest when the underlying market is open, avoid the open and the close and phone in large orders.
To start off, investors should use limit orders to better execute trades.
“If I had to provide just one tip, this would be it. Use limit orders when trading ETFs,” Johnson said.
Investors may rely on market orders to execute an entire order quickly, regardless of the price. While market orders may work for large ETFs that experience huge trading activity, market orders can cause an expectations to go out of sync with reality. Instead, a limit order helps ensure an investor will get the price one has set, but the order may take longer to be filled than an ordinary market order. [Trading ETFs: Why Use Limit Orders]
ETF investors may also want to trade when the underlying market is open. ETFs provide exposure to markets around the world, and U.S.-listed international ETFs may trade during hours when the underlying foreign market is closed, which may result in diverging performance relative to the net asset value. To ensure more closer results to a fund’s NAV, investors can trade Europe ETFs in the morning while European markets are open. However, other markets, like Japan, have no overlap with normal U.S. trading hours, so investors should use limit orders to better control trades. [The Underlying Value of an ETF’s Portfolio]
Johnson also warned against trading near the opening or closing bell. ETF trading activity typically take some time in the morning to gain momentum. Market makers may demand wider spreads in the morning to compensate for the price volatility. At the close, many market makers may also limit their risk, which could cause spreads to widen as fewer are actively quoting prices.
“It makes sense to wait about 30 minutes after the opening bell to trade an ETF and to avoid trading ETFs any time in the half hour leading into the market’s close,” Johnson added.
When executing large bulk trades, an investor should dial in his or her brokerage to help facilitate the trade. Generally, investors should consider help if a trade that makes up 20% of an ETF’s average daily volume or more than 1% of its total assets under management.
For more information on trading ETFs, visit our ETF 101 category.
Max Chen contributed to this article.