Best practices for trading ETFs
Traditional exchange-traded funds (ETFs) combine the intraday trading of stocks with the diversification of mutual funds to create a potentially lower-cost investment solution that can be a powerful tool in portfolio building. However, even the most seasoned investors should consider several factors when buying and selling ETFs.
Making the most of ETF trading
ETFs are lauded for their potential cost efficiency. But in reality, getting the best price means considering several factors before executing a trade.
Consider the order type
The type of order an investor places can have a big impact on cost.
- A market order—an order to buy or sell immediately at the best available price—may lead to less than optimal trade execution.
- A limit order, or marketable limit order, allows investors to set the exact price they are willing to pay or receive for an ETF share, but it does not guarantee the full order will be executed—or executed at all if the market moves. This is generally considered to be the preferred order type for trading ETFs.
Use caution if trading at market open or close
Bid/ask spreads tend to be wider at market open and close,1 so investors should keep this in mind when timing their trades. This happens because:
- Not all of an ETF’s holdings may be trading at market open, making it difficult for authorized participants (APs)2 to price ETFs during the first few minutes of the trading day.
- APs begin to balance their books toward market close and may be reluctant to take on large positions.
Mind volatile market environments
Investors should take care when trading in volatile market environments because extreme market fluctuations can lead to premiums or discounts to an ETF’s net asset value and potentially higher investor costs. They should also keep an eye on earnings reports, general economic releases, Federal Reserve Board announcements, and similar events that may cause a widening of ETF bid/ask spreads.
Understand ETF liquidity
An ETF’s average daily volume is not its only indicator of liquidity.3 Investors should also look at the bid/ask spread and the liquidity of the underlying securities to get a better picture of overall liquidity. In addition, they should keep in mind that differences in trading hours for an ETF’s underlying securities may lead to diminished liquidity in the ETF.
Reach out to a valued broker
ETFs may trade very differently based on the underlying asset class, as U.S. equities, international equities, and fixed-income products have distinct, defining characteristics that directly impact pricing. As certain brokers have comparative strengths in the types of ETFs that they specialize in, investors interested in large trades may consider reaching out to an ETF’s capital markets and sales team for referrals as to which brokers may have inventory or a differentiated ability to provide a better trading experience.
With ETF trading best practices in mind, investors can make more informed trading decisions and potentially use ETFs more effectively in their portfolios.