Tips for trading ETFs
20 January 2015 | ETF information
Exchange-traded funds have become a popular investment vehicle over the past decade. Generally speaking, ETFs blend the investment characteristics of mutual funds with the trading flexibility of individual securities. These attributes introduce differences in how ETFs trade relative to both mutual funds and individual securities, as well as in the approach investors may wish to take in trading them.
We talked with Jim Rowley, a senior investment analyst in Vanguard Investment Strategy Group, about some best practices for effectively trading ETFs.
Why are ETFs popular?
I think ETFs have become so popular because they bring the benefits of indexing through the wide accessibility of a brokerage window. And I'll briefly address all three of those points.
We often hear that ETFs bring the benefits of low cost, diversification and tax efficiency. But what we like to remind investors is that those are benefits provided by indexing, and ETFs are a way or a vehicle of bringing indexing to the marketplace.
A lot of times we hear the term, "Oh, they're bringing it through a wrapper," and that wrapper usually means it is a fund organized as a management company in the United States under the Investment Company Act of 1940. Now that's actually the same regulatory framework under which mutual funds operate. So we like to remind investors that ETFs actually have a lot more in common with mutual funds than they have differences.
I mentioned this wide accessibility through a brokerage window. And this is where I think the really big difference between ETFs and funds comes from. Most Investors are used to mutual funds—putting in their orders and getting an NAV, or net asset value price, at the end of the day. But because you transact an ETF through your brokerage window, you're doing those transactions with a traded market price. And that, we think, is the big difference between funds and ETFs.
Note: In Canada, wrappers often mean that an ETF invests in a U.S.-domiciled ETF. Like mutual funds, ETFs in Canada are governed by National Instrument 81-102.
What are the biggest myths about trading ETFs?
The biggest myth might be that the trading volume is the measure of an ETF's liquidity. It's actually a case where an ETF's liquidity is a function of the ETF's trading volume as well as the liquidity of the underlying securities. So, unlike a single security, which has one layer of liquidity, ETFs actually have two layers. One is the trading of the ETF itself. Generally speaking, the greater the trading volume, the tighter the bid-ask spreads.
The second layer comes from the fact that ETFs are open-end funds. They don't have a fixed amount of shares like a single security. Even for an ETF with low trading volume, large orders can be filled because of the creation of new shares or the redemption of existing shares. Typically, the more liquid the underlying securities, the tighter the bid-ask spreads on the ETF. Therefore, we say liquidity does not simply equal volume. Take a look at an ETF's bid-ask spreads as well.
Let's talk a bit more about debunking some of these myths. What's a basic rule that all investors should follow when trading ETFs?
I think using limit orders is a great first step. Investors are probably used to using market orders where you put a market order in; your order is pretty much filled immediately at whatever the prevailing market price is.
Limit orders give you more price control and protection when putting your order in, meaning, as an investor, you can actually set the price at which you are looking to transact your ETF. The flip side, however, is investors just need to be aware that while a limit order gives you protection and more control, it doesn't necessarily guarantee you the execution. In other words, you might set a price that's a little bit too aggressive and your order might not get filled.
You've suggested investors avoid certain times of day when trading ETFs. Why does it matter what time of day you're trading?
It matters because market makers price the ETFs off of the value of the underlying securities. And generally, what happens at the open of the market or the close is that sometimes bid-ask prices are a little unsettled. For example, you could have market news before the market opens. And as stocks that are affected by that news start their trading for the day, market makers are unsure how the market might react to that news. So the underlying securities might have a bit wider, more volatile bid-ask spreads. Well, as the market starts to digest that news and those bid-ask spreads start to tighten, ETF market makers will see that as an ability to tighten their spreads as well.
What about trading international ETFs? Should investors stay up all night to make sure they're up during the trading hours?
No, I clearly wouldn't recommend staying up all night. And I think some of the biggest concerns we hear about ETFs is the observation that the market price for an ETF might move away from its net asset value.
The reason that happens is that at some point each day all overseas markets close. Everybody in Europe and Asia goes to bed. But here in the U.S., our ETFs are still trading in real time. But information keeps hitting the market here in the U.S. and market participants continue to make prices in ETFs that reflect that new information.
So, really, what market participants are saying—if and when we see the market price of an ETF differ from that set NAV—is "What would the value of this ETF be if those underlying securities markets were still open?"
Can you explain what block trading is and whether investors should be taking advantage of it?
Sure. Block trading refers to trading in large share amounts, say $10,000 or more. Now rather than simply entering their orders on screen, I'd encourage investors to use their block desks. Because block desks have access to alternative forms of liquidity, they might have additional institutional trading strategies to help get best execution on trades that maybe other investors don't normally have.
Based on your research, would you say investors are paying too much when trading in ETFs? Could they avoid this?
More importantly, we want investors to think of the cost structure of ETFs in terms of a phrase that we call "all-in costs." Obviously, we pay a lot of attention to expense ratios, and rightly so. Choosing low-cost funds is a great way to lower the hurdles to achieving investment success.
But with ETFs, you're also going to carry the burden of transaction costs. And although you might not be able to avoid them, we hope that looking at these best practices will help investors to minimize those transaction costs.
Commissions, management fees and expenses all may be associated with the Vanguard ETFs™. This offering is only made by prospectus. Investment objectives, risks, fees, expenses, and other important information are contained in the prospectus; read it before investing. Copies are available from Vanguard Investments Canada Inc. at www.vanguardcanada.ca. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated.
All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Diversification or asset allocation does not ensure a profit or protect against a loss in a declining market. Investing in ETFs involves risk, including the risk of error in tracking the underlying index. ETFs are subject to risks similar to those of stocks.
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