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Ten rules for more effective ETF investing

A number of exchange-traded funds (ETFs) traded at substantial discounts to net asset values (NAVs) during bouts of substantial volatility in late 2015 in the United States and Chinese share markets. While funds' prices quickly snapped back and came into alignment with their underlying NAVs and the trading anomalies were short-lived, it was a reminder of the need for caution in ETF trading in tumultuous markets.

We haven’t seen anything like those disparities in Australian-listed ETFs, but it is worth revisiting some rules of thumb for transacting in ETFs which, if followed, should reduce the chances of local investors being impacted by such events.

1. Use limit orders rather than market orders

Market orders (ie an order to fill the trade at the best available price) tend to be used when time is of the essence and price is of secondary importance. Investors using market orders want to execute their entire order as soon as possible. For very large, very liquid ETFs that trade contemporaneously with their underlying securities, market orders will likely result in fast execution at a good price.

But there are smaller or less liquid ETFs, and there are also ETFs that trade out of sync with their constituent securities (such as U.S. equity ETFs where there’s no overlap between Australian and U.S. trading hours). Limit orders (ie an order to fill with a specific price limit) will ensure favourable execution from a price perspective. A buy limit order will fetch the buyer a price less than or equal to the limit price, while a sell limit order will transact at a price greater than or equal to the limit price.

2. Avoid trading at open, close, or in the auction period

For ASX-listed ETFs, this means at the very least, avoiding trading earlier than 10:15am or later than 3:45pm. At these times, market-makers may not be watching the market as closely, and some underlying stocks may not be trading, making it more difficult for the market-maker to calculate an accurate price.

3. Be wary of transacting when the underlying securities are not open for trading

With transparent pricing of the underlying stocks, trading volumes should be substantially higher, and bid/ask spreads will typically be lower. For example, trade Asian ETFs in the afternoon, once the Hong Kong, Singapore, and Shanghai exchanges are open.

4. Check the bid/ask spread

If the bid/ask spread is wide, it may indicate that something is amiss, and it might pay to delay your trade or dig further.

5. Check trading volumes and ETF size

An ETF’s on-screen trading volume doesn’t tell the whole story. The liquidity of the underlying assets is arguably more important, because the market-maker can create or redeem ETF shares to balance supply and demand, as long as the underlying market is liquid. However, the size of an ETF and on-screen volume are worth monitoring, particularly for ETFs where the underlying assets trade outside Australian hours.

6. Use the available tools

ETF providers offer tools such as the intraday NAV (iNAV) which can help gauge whether an ETF is trading near its net asset value (NAV). Although there’s no guarantee the iNAV will be an exact representation of the NAV, it’s a useful indicator. Check the iNAV before trading.

7. Apply a common sense check

Ask yourself: is there anything unusual here? Is the ETF price substantially different from the previous day, or even from a few minutes ago? Is the ETF price stable while underlying markets are rising or falling? Are markets going through extraordinary volatility? If so, further research or patience may be required before placing a trade.

8. Be careful about using stop-loss strategies

Stop-loss strategies caused serious problems for some U.S. investors in the recent market turmoil. The U.S. sharemarket gapped downward because of a lack of liquidity at that moment, which triggered stop-loss orders. Because some of these stop-losses were market orders, they were filled at any price available, and with limited liquidity at the time, may have caused an even bigger drop in prices. We advise caution using stop-loss strategies, especially if they’re triggered automatically, or use market orders.

9. If in doubt, contact the ETF provider or market-maker

The ETF provider (or for large investors, the market-maker) can answer questions about trading an ETF and explain anomalies. If in doubt, contact the ETF provider or market-maker before trading.

10. Remember – it’s all about your investment strategy

Investors investing for the long term may have fewer worries when transacting ETFs. If a volatile market causes bid/ask spreads to widen, a long-term investor can be patient, waiting to execute their trade when volatility has subsided. In contrast, a short-term trader may be forced to exit a trade quickly, no matter what the cost. Nevertheless, if an ETF doesn’t help you achieve your investment goals and strategy, or fit with your tolerance for risk and investment time horizon, then it’s unlikely to be the best fit for you, no matter how attractive an investment proposition it seems.

 

Alex Prineas is a Research Analysts at Morningstar. This article is general information and does not consider the investment needs of any individual.

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