ETFs are structured much like mutual funds, in that they hold an underlying basket of investments in which investors have proportional ownership stakes. But when it comes to buying and selling them, the strategies involved sometimes make them more akin to stocks.
Unlike mutual funds, ETFs have intraday liquidity, so the price at which they’re bought and sold can deviate from their net asset value (NAV). But unlike stocks, ETFs have a secondary source of liquidity: designated brokers (also known as authorized participants) are allowed to exchange the underlying basket for units with the fund company.
This ability to create and destroy units limits the impact of large orders. It also means liquidity ultimately rests in the underlying investments: The less liquid an ETF’s holdings are, the less liquid the ETF is likely to be.
Read: More advisors using ETFs to mitigate risk
It’s also important to remember that buying and selling ETFs costs money just like stocks. Brokerage commissions can add up quickly for your clients if they trade frequently, especially if their account has high fees.
With that in mind, here are some suggestions for placing ETF orders that can improve your clients’ returns.
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Avoid placing orders near the open and close
In the morning, ETF prices may adjust to the difference (premium or discount) between the previous day’s closing price and their NAV. This can result in ETF prices moving in the opposite direction of the underlying holdings. These gaps may persist for some funds and tend to be larger for funds that track foreign markets.
In the morning, adjustments are also occurring to an ETF’s underlying stocks as they open. Approaching four o’clock, market makers (working for the designated broker) often begin to take down positions and hedge their books (especially in funds that track foreign indexes). These factors increase an ETF’s volatility, often resulting in rapid price changes and wide spreads between the bid and the ask price. A good practice is to avoid placing orders during the first and last 30 minutes of trading.
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Use caution during volatile days
During days of heightened volatility the underlying stocks’ movements can temporarily throw an ETF’s underlying value off its bid-ask spread. As well, the bid-ask spread will likely widen.
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Use limit orders for best execution
When there’s a wide bid-ask spread, placing a limit order and letting the market come to you may help. Limit orders define the price you’re willing to pay, thereby limiting your market impact.
Market orders, which execute at the best available price at the moment, are fine for ETFs with tight spreads and good liquidity relative to your order size. However, these characteristics are uncommon in many Canadian funds. The risk with using a limit order is that your order doesn’t get filled and you miss out the ETF’s move.
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Select ETFs with good liquidity
If possible, select funds with tight bid-ask spreads and good 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. Large orders, which are more concerned with price impacts, generally benefit from the market makers’ ability to keep prices close to the NAV and execute large block trades.
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Trade while the underlying market is open
If you are investing in an ETF that holds foreign securities, such as European or emerging market equities, you should consider investing only while the underlying market is open, if possible. It’s also important to note many commodities markets don’t have the same hours as the regular stock market. For instance, the Chicago Board of Trade’s grain contracts don’t open until 10:30ET and they close at 2:15ET. By restricting your trades to mutual hours, you are less likely to pay up for the uncertainty.
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Consider using a stop-loss order
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. Another valuable type of stop-loss is a trailing stop-loss, which ratchets up the stop-loss price as your ETF’s price increases. This way, you can let your winners run while virtually locking in your gains.
A common risk with this strategy is for the ETF’s price movements to trigger the sell only to subsequently move back in your favour, causing you to miss the upside. This is one of the reasons why setting a stop-loss is more art than science. Set it too narrow and you risk exiting your position prematurely. Set it too wide and you risk taking on a greater loss. Generally, stop-loss orders are better suited to short-term momentum plays, rather than long-term value investments.
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Pay attention to transaction costs
High brokerage fees are a sure way for your clients to reduce their returns. Consider the cost of each leg of the transaction. These costs become particularly important if you’re frequently investing a small amount of money. If that’s the case, an index mutual fund may be a better option if you can find a similar one.
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Be careful when using leveraged ETFs
These products exacerbate price movements, making it even more important that you receive good execution. Since they are designed to track daily movements of an underlying index or futures contract, holding them for longer periods will result in deviations from the underlying benchmark. If you want to maintain your exposure, you’ll have to rebalance often, which is costly.
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Consider the number of 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. To determine who’s making a market for an ETF, either ask the fund company or watch the broker ID (if you receive level-two quotes).
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Be mindful of the distribution date
Most ETFs are very tax efficient since they have low turnover. However, there’s the potential that people holding these products on the day of record can incur large negative tax implications. It’s especially true for smaller leveraged and inverse ETFs. This happened in the United States, where an inverse-leveraged ETF’s capital gains distribution was over 73% of its NAV, and three other ETFs had distributions in the 20% range. The conditions required are generally a large run-up in the value of the underlying contracts, followed by significant redemptions that force the ETF to sell its positions instead of passing them off to the designated broker. While rare, it’s a high-impact event.
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