Exchange-traded funds (ETFs) trade somewhat differently than individual securities or even mutual funds. For this reason, understanding the fundamentals of order placement, volatility and liquidity are critical for boosting returns and minimizing risks in the ETF market. Whether you’re an active trader, retail investor or financial advisor, the quality of your trade execution matters.
Global ETF assets topped $3 trillion in 2016, as the combination of transparency, tax efficiency and cost savings continue to attract investors to the market. ETFs under management have doubled since 2010 and are forecast to double again by 2021. To capitalize on this rapidly expanding market, it is crucial to understand how it operates and what makes ETF investing unique from other asset classes. As ETFs continue to proliferate and increase in complexity, advisors and investors need to take the necessary steps to educate themselves on the nuances this market offers. Read Ten Commandments of ETF Investing for more information.
One of the most fundamental aspects of trading ETFs effectively is order execution. The difference between an ETF’s intraday price and the fund’s net asset value (NAV) is the largest at the beginning and end of the trading day. An ETF’s NAV refers to the total value of all its underlying holdings at their closing prices. As such, the NAV is calculated at 4 p.m. ET Monday through Friday.
Unlike mutual funds, ETFs are traded throughout the day, which means there are times when the NAV and actual market price don’t perfectly align. While the difference tends to be very small, it can make the calculation of performance slightly more challenging. That’s why it’s important to execute ETF orders close to the NAV orders, which means you should steer clear of trading immediately after the market opens or just prior to its close. These periods are known to be the most volatile.
ETF orders that are not executed close to the NAV can create a large discrepancy between total returns and potential returns over time. For example, orders that are executed at the intraday market price can vary from the NAV by several basis points. Over the span of months and years, that discrepancy can be quite large, especially for index investors who prioritize cost savings.
To maximize your returns when buying and selling ETFs, consider the following best practices.
1. Be Aware of Trading Activity in the First and Last 15 Minutes of the Trading Day
With a newfound understanding of the difference between intraday and NAV prices, investors should be cautious of trading activity in the first and last 15 minutes of the trading day. Investors can expect greater volatility toward the end of the day as market makers balance their books, leading to wider spreads. A good rule of thumb is to restrict buying and selling to 30 minutes after the market opens and 30 minutes before the market closes.
2. Choose Limit Orders
Limit orders help investors pre-determine their buy and sell price points. When trading ETFs, limit orders specify the exact price at which you are willing to enter or exit a position. While this is never an easy decision, it can help you protect against a declining market in the case of a stop-loss order. In ETF trading, a limit order is considered more effective than a market order, which is subject to a bid-ask spread that can widen significantly if there are few shares available for a given price. In this case, a limit order can help remove uncertainty from your decisions.
3. Steer Clear of Trading During Volatile Periods
Unless you’re trading volatility-related ETFs, such as the (VXX ), periods of uncertainty should be avoided. Volatile conditions can lead to a sharp divergence between the ETF’s intraday price and the fund’s NAV. When the price of an ETF is trading above its NAV, it is said to be trading at a premium. If the price of the ETF is below the NAV, it is said to be trading at a discount. For example, when an ETF’s underlying securities become less liquid or markets are experiencing heavy order flow, transaction costs may increase, leading to larger premiums and discounts. As we outlined previously, ETF investors want to execute orders as close to the NAV as possible. For these reasons, volatile conditions normally aren’t effective when it comes to ETF investing.
4. Be Aware of Liquidity
ETFs are widely regarded as a more liquid alternative to other asset classes, such as mutual funds. However, this advantage can only be realized if you invest in ETFs with high trading volume. While high volume doesn’t always lead to liquidity, it can narrow the ETF’s bid-ask spread. A market with higher volume is usually much tighter, thereby lowering your transaction costs and ensuring you can enter the market at a desirable price. Investors also look at implied liquidity when deciding which funds to buy. Implied liquidity is a measure of what can potentially be traded based on the ETF’s components rather than average daily volume. For successful investing, implied liquidity and average daily volume should be used in tandem.
5. Trading “Large Blocks” of ETFs
As the ETF market expands, investors and advisors have begun trading large blocks of ETFs to maximize liquidity, assets under management and overall returns. While the definition of a “large block” can vary, it generally refers to anything above 5,000 or 10,000 shares. Large blocks have the added advantages of minimizing market impact risk and facilitating the best possible average trading price. To block trade effectively, order sizes may be calculated by dividing the shares by the average daily volume, a practice that reduces liquidity bias. Investors also rely on powerful algorithms and automated platforms to execute the best possible trade. Block trades are usually made through an intermediary that specializes in such transactions. These institutions can help investors weed out volatility when trading large blocks of shares.
6. Trading International ETFs
International ETFs can provide exposure to both advanced and emerging markets. Regardless of which part of the world you invest in, it’s best to enter a trade when the local markets are open. That’s because information flows do not cease when an international market is closed. New information can impact the prices of the international ETF’s components even though it is not yet reflected in the security’s price. If the international ETF’s local market is closed, the new information is incorporated into the ETF’s market price, which can lead to bigger premiums and discounts relative to the ETF’s NAV.
For example, U.S. traders of the Vanguard FTSE Europe ETF (VGK ) are likely to see narrower spreads and prices closer to the real-time NAV during the morning hours when the underlying securities are still trading in their local European markets. These factors break down in the afternoon, when local European markets are closed. You can utilize our ETF Screener to filter through the entire universe of ETFs, including international ETFs, by various criteria, such as asset class, expenses, performance and liquidity.
The Bottom Line
As ETF trading grows more powerful and complex, best practices related to order placement, volatility and liquidity can help illuminate the path to success. The six best practices you learned about in this article can help you boost earnings, lower costs and avoid costly mistakes in the market. For additional tips on ETF trading, read 3 ETF Trading Tips You Are Missing.
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