1. Exchange-Traded Funds: Introduction
  2. Exchange-Traded Funds: Background
  3. Exchange-Traded Funds: Features
  4. Exchange-Traded Funds: Biggest ETFs and ETF Providers
  5. Exchange-Traded Funds: Active Vs. Passive Investing
  6. Exchange-Traded Funds: Index Funds Vs. ETFs
  7. Exchange-Traded Funds: Equity ETFs
  8. Exchange-Traded Funds: Fixed-Income and Asset-Allocation ETFs
  9. Exchange-Traded Funds: ETF Alternative Investments
  10. Exchange-Traded Funds: ETF Investment Strategies
  11. Exchange-Traded Funds: Best Practices for Trading ETFs
  12. Exchange-Traded Funds: Conclusion

Some of the biggest ETF providers including Vanguard have compiled a list of best practices for trading ETFs. These include –

  • Avoid trading around market open and close: Investors should avoid trading ETFs right around market open and close because of greater volatility during these times which would result in wider bid-ask spreads. Generally, all of the underlying securities in an ETF will not start trading as soon as the market opens, which makes it difficult for the market maker to price the ETF accurately. As a result, to limit risk, the market maker may price the ETF with a wider bid-ask spread than usual. Similarly, since trading activity winds down as the 4 p.m. EST market close approaches, fewer market participants are willing to make markets for the underlying securities, which again translates into higher volatility and wider spreads.

 

  • Use limit orders instead of market orders: In a limit order, the investor sets the specific price at which he or she is willing to buy or sell a security. In a market order, the investor simply gets the current bid price (when selling) or the ask price (when buying). A limit orders thus gives the investor a greater degree of control and protection over the price of the transaction, which can be a very important consideration when markets are volatile. For example, during the “Flash Crash” of May 2010, many ETFs traded at prices that were 60% lower than their prices just prior to the crash. The risk of not getting the trade executed with a limit order is offset by the likelihood of getting a better price for your buy or sell transaction, compared to a market order. (Related: What's the difference between a market order and a limit order?)

 

  • Exercise caution during volatile periods: Periods of enhanced volatility can cause an ETF’s share price and NAV to disconnect from the value of the underlying securities. The situation may be exacerbated by the underlying securities themselves trading at wider bid-ask spreads, resulting in the ETF also trading at wider spreads. Investors should try to avoid trading ETFs during such volatile times, or at least use limit orders if they have to trade.

 

  • Watch liquidity by monitoring bid-ask spreads: Tight bid-ask spreads are a good indicator of ETF liquidity. As noted earlier, it may be prudent to refrain from trading ETFs during volatile periods, when bid-ask spreads may widen substantially, indicating that market conditions are constraining ETF liquidity. (Related: The Basics Of The Bid-Ask Spread)

 

  • Trade international ETFs when foreign markets are open: Since ETF prices are based on prices of their underlying securities, international ETFs’ prices will be closer to their real-time NAVs when their underlying securities’ markets are open. When overseas markets are closed, market makers will price U.S. market movements into international ETF prices, even though their underlying securities do not yet reflect these moves. For example, if the U.S. market falls 2%, market makers may price international ETFs 2% lower as well, on the assumption that their underlying securities will face a similar price decline when trading commences on their markets. This can cause significant tracking error and increase trading costs, which can be minimized by trading these ETFs when international markets are open.

 

  • Track distribution dates: Although most ETFs limit the amount of tax distributions, exceptions occur from time to time. In December 2008, with stock and commodity prices in freefall on account of the global credit crisis, a number of inverse leveraged ETFs paid out large amounts of capital gains to investors. Most of these capital gains were short-term in nature, and as a result would have been fully taxed as ordinary income in the hands of the investors. If an ETF has announced a large distribution, it may be best to delay the purchase of the fund until after the record date of the distribution, since buying it before the distribution is made will result in an unexpected tax liability.

 

  • Watch out for pricing anomalies: Pricing anomalies do occur with ETFs, with prices occasionally diverging significantly from their underlying securities. Prior to buying or selling an ETF, investors should check its intraday indicative value (IIV), which is based on the ETF’s previous day’s holdings and is a widely disseminated real-time estimate of its underlying value. Buying or selling the ETF near its estimated NAV will help the investor minimize unnecessary trading costs. 

 

 

 

 

 

 

 

 


Exchange-Traded Funds: Conclusion
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