Exchange traded funds, like the appellation suggests, are funds traded on an exchange, similar to what investors have been doing with common company stocks. Consequently, potential ETF traders should keep in mind the same considerations one would normally think about when trading stocks.
“The exchange-traded nature of these funds is increasingly taken for granted as many of the largest ETFs trade at tight spreads in very narrow bands around their net asset values through most market conditions. But not all ETFs are created equal from a liquidity perspective, and investors shouldn’t take ETFs’ liquidity for granted,” Ben Johnson, Morningstar’s Director of Global ETF Research, said.
Consequently, Johnson has outlined some useful tips on how to best trade ETFs, including things like the use of limit orders, when to trade and how to execute trades.
For starters, Johnson suggests investors should use limit orders. Many investors tend to simply rely on market orders to execute a trade as soon as possible. For very large and liquid ETFs that are commonly traded, market orders will be pushed through in a quick and efficient manner. However, less actively traded options may trade out of sync with their constituent holdings. Consequently, the use of limit orders helps ensure a good price or better control over the price of an ETF trade.
“If I had to provide just one tip, this would be it. Use limit orders when trading ETFs,” Johnson said.
When Investors Should Trade
Investors should trade when the underlying market is open. If one is looking into an international stock ETF, it is best to trade the ETF when constituents are actively changing hands in their home market or when the target market is actually open. U.S. internationals can provide foreign market exposure, even when those markets are closed during normal U.S. hours. However, there are some ETFs that track markets that never trade during U.S. hours, like Japan, so investors should then seriously consider limit orders to better efficiently price trades.
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Johnson also advised ETF investors to not trade during the open or close of a normal trading day due to the wider spreads since it takes a moment for the markets to “wake up” at the beginning and more traders step back from the markets near the close.
“In light of these considerations, it makes sense to wait about 30 minutes after the opening bell to trade an ETF and to avoid trading during the half hour leading into the market’s close,” Johnson said.
Investors who are executing large trade orders may think about talking to a professional to help efficiently push it through. Johnson describes large orders as anything that accounts for 20% of an ETF’s average daily volume or more than 1% of total assets under management. A large investor may save on execution cost by talking to the ETF provider’s capital markets team or a market maker so as to execute a large trade without negatively impacting the market price.
For more information on investing in ETFs, visit our ETF 101 category.