10 tips for more effective ETF investing

We know investors are always hungry for investing tips, including information about exchange-traded funds, so these 10 timeless tips are worth revisiting.

Morningstar Analysts 28 June, 2019 | 3:05AM
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We know investors are always hungry for investing tips, including information about exchange-traded funds, so these 10 timeless tips are worth revisiting. The following rules of thumb for ETF transactions have been published before, but each one of them remains just as relevant in 2019 as it was five years earlier.

1. “No Limit” is a poker game, not an investment strategy.

You should consider using limit orders, not market orders. The latter can be useful when time is of the essence and price is of secondary importance, or when there is plenty of liquidity.

Investors using market orders want to execute their entire order as soon as possible. For 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. Limit orders help 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 TSX-listed ETFs, this means at the very least, avoid trading earlier than 9.15 a.m. or later than 3.45 p.m. 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. 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. It is also worth observing the bid/ask spread to see if it is unstable, that is, narrowing and expanding frequently. If so, it’s a sign market makers are adjusting for risk and caution may be required.

4. Be wary when transacting while underlying securities aren't open for trading

ETF trading volumes should be substantially higher and bid/ask spreads will typically be lower when the underlying stocks are also trading and have transparent pricing.

5. Use the available tools

ETF providers offer tools such as the intraday NAV, or iNAV, which can help gauge whether an ETF is trading near its NAV. Although there’s no guarantee the iNAV will be an exact representation of the NAV, it’s a useful indicator. If there is one, check the iNAV before trading.

6. Check trading volumes and ETF Size

An ETF’s size and on-screen trading volume doesn’t tell the whole story, but it's an important part of it. The liquidity of the underlying assets is arguably most 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 Canadian hours. For example, for global equity ETFs, the on-screen volume may be more important than ETFs that hold assets trading in local hours. As a general rule, the larger the ETF size, the less likely investors are to have problems trading it.

7. It’s hard to make a bad trade if you don’t trade

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, has there been a distribution on the day but the price hasn’t reduced accordingly? If so, further research or patience may be required before placing a trade. That said, sometimes it’s best to trade regardless of the transaction costs, if you’ve realised that your thesis was wrong. Apply a commonsense check to make your decisions, avoid emotions, and rely on your intellect and good advice.

8. Stop-loss strategies may not stop your losses

Stop-loss strategies can lose more money than they save, especially during market turmoil. For example, in the 2015 volatility in the US, the market gapped downward because of a momentary lack of liquidity, 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, which may have caused an even bigger drop in prices. Investors with stop-loss orders may have sold out at the bottom. We advise caution using stop-loss strategies, especially if they’re triggered automatically or use market orders. Price alerts can be used instead.

9. If in doubt, give a shout

Contact the ETF provider or market-maker if anything looks odd or you’re unsure of something. The ETF provider can answer questions about trading an ETF and explain anomalies.

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

Long-term investors will likely have fewer worries when transacting ETFs. If a volatile market causes bid/ask spreads to widen, a long-term investor can ride it out. Should trading be necessary, then they can wait 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. It can be a very high cost to do a panic trade when spreads are widened, and investors will need to carefully weigh up whether it is more important to trade and incur the cost, or if they can afford to wait.

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.

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