ETFs have lowered the barriers to entry for the investment industry. Assets that were previously considered to be off-limits or at best out of reach for retail investors are now easily accessible. In other words, one doesn’t have to be a seasoned stockbroker or a venerable institutional investor to trade these vehicles.
But as simple as ETFs are to trade, there are still a lot of moving parts, and some things can still be easily overlooked or forgotten.
With that in mind, here are three things to consider when trading ETFs:
Make Sure the Market is Open
Consider this: If you’re buying an ETF on the New York Stock Exchange that has positions in overseas stocks, are you making that trade when those stocks are trading? Asking if the underlying market you’re looking to access is open for trading is a question that investors often forget when buying into a position, particularly when trading ETFs that offer exposure to foreign equities, commodities, or currencies. Forgetting this could cost you money.
Dave Nadig, director of research at ETF Trends, explains that, when trading, particularly in size, the on-screen pricing you see is influenced heavily by how easily an Authorized Participant (AP) can buy or sell the basket of securities they need to interact with the issuer. But if the basket isn’t trading, the AP can’t efficiently enter a transaction to correct pricing back to fair value.
“If you are buying a Japan ETF in the U.S., the AP literally can’t do a creation,” says Nadig. “They could sell you 50,000 shares of the ETF, but they have to wait until this evening to actually buy the underlying stocks. That introduces risk to their profit, so they simply ‘charge more’ in the form of allowing spreads to widen, or by allowing trading pressure to diverge from ‘fair value’ more than you might expect.”
So, remember: European stocks traded on the Euronext are open for trading until 10:30 AM EST, while the London Stock Exchange is open until 11:20 AM EST. Stocks traded in Australia, China, and Japan don’t overlap with Wall Street trading hours. Meanwhile, for commodity traders, metals futures on the Comex Metals Exchange are traded from 8:20 AM to 1:30 PM EST, and grain futures at the Chicago Board of Trade are traded from 10:30 AM to 2:15 PM EST.
Consider Spreads and Learn to Love Limit Orders
When looking at an ETF quote, check out the “bid” and “ask” prices. The bid price is the highest advertised price you can get right now as a seller. Likewise, the ask price is the lowest advertised price you can pay if you’re looking to buy.
For your next trade, consider placing your limit order somewhere inside the bid-ask spread. This way, you may be able to cut trading expenses by getting a better deal on the price at which you bought or sold.
“Anytime you enter a market order, you are in effect saying, ‘I don’t care about the price at ALL, but I care about how quickly this gets executed a LOT,‘” Nadig explains. “It’s a recipe for bad execution. With a limit order, you’re saying, ‘This price or better, I’ll wait.’ And you can choose a price that’s actually even a little worse than what the market might be saying.”
For example, If the bid is $40.20, and the ask is $40.40, try placing your buy limit order at $40.25 and see if you can get filled at a lower price than what’s being advertised.
“Keep in mind that volatile markets can also spell uncertainty for ETF pricing,” notes guidance from American Century Investments. “Market swings can cause the prices of the underlying securities to move sharply, leading to wider bid/ask spreads or larger premiums and discounts for the ETF.”
Be Mindful of Distribution Dates
Although ETFs are designed as tax-efficient vehicles, sometimes unforeseen tax distributions can have material consequences. For example, leveraged and short ETFs can incur noteworthy short-term capital gains if the value of the underlying derivative contracts soars and there’s a massive shareholder redemption.
Such a scenario would in turn force the fund manager to sell the positions and pass on the gains to remaining shareholders. As such, large tax liability events can certainly lead to volatile trading for certain ETFs.
As Nadig notes, you don’t want to buy an ETF at $100 on Monday and then find out it trades “ex-dividend” on Tuesday down $10. “You don’t lose the $10, a few days later you get the dividend in your brokerage account, but you then have to deal with tracking the cost basis and potentially paying taxes on those dividends you’ve only held for a day,” he says. “Although technically it’s not a huge problem, it is losing a timing option, particularly around taxes."
So, be aware of upcoming tax distributions dates for the ETFs you own. It’s also a good idea to keep an eye out for large pending tax liabilities on funds you’re looking to buy, because you may be able to get in at a better price after the distribution record date.
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