Exchange-traded funds continue to gain in popularity among
financial advisers, but some fall into trading traps that can add unnecessary
expense for their clients. These mistakes can chip away at what is one of the
main appeals of ETFs-–their low cost structure. Some types of slip-ups would
seem obvious, such as forgetting to use a limit order to ensure the price that
is paid for shares isn’t too high or the sale price too low. Others are less
apparent, and may become clear only after doing some homework. Financial
advisers were among the early adopters of ETFs, which can be bought and sold on
an exchange at prices that change throughout the market day, unlike mutual
funds, which set their prices only at the end of each trading day.
There seem to be three camps of advisers using ETFs. In the
first are those who use them to trade relatively often, typically on technical
signals. The second group includes those who typically invest in stocks, but
park cash in ETFs temporarily when they don’t see a clear market trend. The
third is made up of those who use ETFs as a long-term investment tool. It is
noticeable to see advisers in every group making missteps.
Most financial advisers--including registered investment
advisers, independent advisers and brokers--regardless of their size, aren’t
trading ETFs for the short term. It is important for them to know their current
underlying value, average daily trading volume, liquidity and, most
importantly, the bid-ask spread--that is, the difference between the highest
price a buyer is willing to pay and the lowest price a seller is willing to
accept.
Bid-ask spreads for most ETFs are very tight, indicating
that the funds are accurately tracking the value of their holdings. With some
new, small or thinly traded ETFs that spread can widen, however. It is recommended that an adviser confirm the
bid-ask spread with his broker’s trading desk before placing an order--and then
make sure in most instances that it is a limit order, not a market order. The
latter means paying the best available price, even if there’s an unexpected
swing in price.
An adviser may not expect his own order to move an ETF’s
price, but even small orders may do so if a fund is thinly traded. But while
that may work when buying or selling large-cap stocks, with ETFs, liquidity may
be constrained in the hands of market makers (broker-dealers who seek to
provide continuous liquidity to the market) or other authorized participants,
who help to create and redeem ETF units.
On the other hand, even in cases of thinly traded funds
there may be the possibility for an adviser to make a relatively large order,
particularly if the underlying assets are fairly liquid. To determine if such
an order can be effected, the adviser should first talk to a market maker or
other participant.
Ian Schaad, managing director of ETF sales and trading at
Jane Street, says the bigger the percentage of an ETF’s average daily trading
volume an investor plans to trade, the more care he should take to obtain all
the appropriate information. He and others also advise that investors trade
only when the market for the underlying securities that an ETF tracks is open,
and avoid trading right at that market’s open or close.
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