Exchange-traded funds (ETFs) offer the best of both worlds—the diversification of a mutual fund/index and the real-time tick-by-tick trading opportunities of a stock. These traits have made ETFs a very popular investment vehicle (see related: The Benefits Of ETF Investing). Once you’ve chosen your ETF and made an entry, how long do your hold your position? A successful ETF trader has an exit strategy that tells when to close the ETF position by booking profits or by cutting losses. (See related: Exchange-Traded Funds: ETF Investment Strategies.) 

This article identifies five important signals that it's time to exit the ETF position. 

1. The ETF Shows Tracking Errors

ETFs usually track an underlying index, like the S&P 500, or a particular commodity, like gold. However, this tracking may not be perfect despite the best efforts of the ETF fund managers and trading participants. Deviations may be due to lack of liquidity in the trading of the particular ETF or time gaps between changes to underlying index constituents and the ETF portfolio replicating these changes. These factors introduce the tracking error, which essentially means a difference between the ETF performance and the performance of the underlying index or commodity. Once the tracking error begins, it may grow and cause significant deviations between the performance of the underlying and that of the ETF. Traders and investors should keep a regular eye on the tracking error, be aware of the major deviations and understand the factors that led to the tracking error. If the tracking error is increasing, or the causal factors are changing leading to possible impacts on ETF performance, it’s time to exit the ETF.

2. The ETF Shifts Its Focus

Along with standard indices, many popular ETFs are based on derivatives like futures or complex combinations of leveraged positions (see related: Futures Exchange-Traded Funds). For example, United States Oil Fund LP (USO) may not necessarily track the price of oil as it actually holds oil futures contracts. The ProShares Ultra QQQ ETF (QLD) aims for doubling the daily return of an index or benchmark. However, it may not necessarily provide 200 percent return on the underlying benchmark, as it actually holds index swaps. Amid changing market conditions with respect to ETF holdings, the ETF fund managers are constantly evaluating and rebalancing their mix of securities by changing the underlying holdings within their scope. For example, ProShares Ultra QQQ (the QLD holding) is primarily comprised of index swaps. Its fund managers may change the variety of index swaps and even include stock positions. ETFs also hold some part of their capital in cash and short-term money instruments in order to accommodate redemption requests.

All these practical changes may lead to an ETF migrating from its original investment strategy. Many ETF traders take a position based on a certain strategy. For example, a trader may wish to invest 20% of his trading capital in oil, so he puts his money in an attractive oil ETF. If, after some time, this oil ETF begins deviating from its earlier oil-based holding composition, the trader should consider exiting the position as it no longer fits into his overall trading strategy. (See related: An Inside Look At ETF Construction.)

3. The ETF Declines in Liquidity

There can be many ETFs tracking the same underlying index. For example, the S&P 500 Index is tracked by SPDR S&P 500 ETF Trust (SPY), iShares Core S&P 500 ETF (IVV) and the Vanguard S&P 500 ETF (VOO). Although they may all track the same underlying index, not all ETFs are created equal. The price chart below shows a comparative performance of SPY, IVV and VOO, all ETFs tracking the S&P 500 Index.  You can see there is up to a 5 percentage point difference in performance (graph courtesy of Google Finance). Inevitably, some ETFs will be more popular than others. When an ETF has more market participants trading more often, it has greater liquidity and its direct competitors may have less liquidity. But popularity can be fickle. A once hotly traded ETF may decline in liquidity as investors migrate to exciting new fund launches. A decline in ETF trading liquidity impacts the ETF performance as it trades in open market and is subject to market pressures. Any patterns of decline in ETF liquidity over a few weeks or months is a clear signal about overall market participation waning in the ETF.

Investors should see this as a clear sign to exit the ETF.

S&P500 ETF Historical Performance

4. The Movement Meets Your Profit-Taking Strategy

No trading can succeed without a planned profit-taking strategy. Successful traders finalize their profit-taking levels and profit-taking strategies even before they enter into a trade. Strategies can include booking partial profits as the prices move favorably; scalping, which involves taking frequent profits on small price changes; selling at predetermined stop-loss levels or following technical indicators for profit taking. (See related: Day Trading: Top Scenarios To Take Profits and Scalping: Small Quick Profits Can Add Up.)

5. The ETF Trading Scenario Shifts

One enters a trade when a particular scenario of his choice occurs. For example, a technical indicator indicating long position entry, a momentum strategy recommending a short position or a fundamental analysis indicating increased demand for a commodity like gold for next 12 months are common entry signals for ETFs. Once in the trade position, a trader should regularly assess if the entry scenario has changed. For example, is the same technical indicator now deferring from the earlier recommendation of long position? Is the momentum strategy no longer showing continued momentum for the short position and instead suggesting a turnaround? Does fundamental analysis now show decreased demand and increased supply of gold? All these changes to the trading scenario since the entry position provide important signals to exit the trade before it starts losing money.

The Bottom Line

ETFs offer the advantages of diversification with the ease of trading a single stock. But these mixed advantages also increase the complexity for trading ETFs. Multiple factors affect the entry and exit scenarios. Short-term frequent trading of securities requires a disciplined approach which is free of emotional biases, and the same applies to short-term ETF trading. ETF traders need to be alert to changes in the underlying holding patterns, causal factors impacting ETF performance and signs to exit the ETF. (Further suggested reading: Building An All-ETF Portfolio.)