Tips for Trading ETFs

I happened to have Google Finance open on my computer last week when the “flash crash” happened. While the market’s whipsaw on May 6 affected almost all stocks, it seems that ETFs were particularly hard hit: I watched my position in the iShares S&P/TSX Capped REIT Index Fund (XRE) fall 15% in a matter of minutes. The ETF, which opened the day at $12, eventually fell to $6.89. I missed that low point, as I was standing on the ledge of my home office window, poised to hurl myself onto the dandelions below.

I’m not sure we’ll ever know the full story behind the madness of May 6, and for long-term investors it’s probably not worth fretting about. But the day was a reminder that ETFs, unlike mutual funds, are potentially vulnerable to the insanity that occasionally plagues stock exchanges in this era of automated trades. If you’re building a portfolio of ETFs in a discount brokerage account, here are a few suggestions to make sure your trades go smoothly:

Choose frequently traded ETFs. In theory, ETFs are supposed to be infinitely liquid: that is, you should be able to buy or sell units at market prices very close to the net asset value (NAV). But unpopular ETFs may be subject to wider price fluctuations and higher overall expenses. This is not an issue with the broad-based equity funds from iShares or Claymore: any ETF that trades at least a few thousand shares every day should not cause concern. But some of the newer and more specialized ETFs are traded very infrequently: the iShares Portfolio Builders have days when only a few hundred shares change hands, and some of BMO’s new ETFs go entire days without a trade.

Look for a tight bid-ask spread. The bid-ask spread is the difference between what you pay for an ETF when you buy it and what you’ll receive when you sell. Ideally, this spread should be one or two cents: any more and you’re paying too much to the broker. ETFs with high trading volumes usually have tight spreads, but not always, so check before you enter your order.

Make sure the market price is close to the NAV. When you research an ETF on the provider’s website, both the net asset value (NAV) and yesterday’s closing price are listed. The NAV represents the per-unit value of the underlying securities, so in theory it should be what investors are willing to pay for one share of the ETF. But again, that doesn’t usually hold true in practice. Most ETFs trade at a slight premium or discount to the NAV. If you can buy an ETF for less than the NAV, you should be pleased. Paying a few cents over the NAV price is not a big deal, but occasionally you’ll see ETFs trading at a premium of 2% or 3%. Do you really want to pay that much more than the underlying securities are valued at?

Watch the clock. Differences between the NAV and the market price tend to be widest in the first half-hour after the markets open, and in the 30 minutes before they close. So if you’re buying or selling an ETF, do it toward the middle of the trading day to ensure that price discrepancies are minimized. If you’re buying an ETF that holds European stocks, consider making your trade between 10 and 10:30 am EST: this is the only window during which both the North American markets and European markets are open, which can also reduce price discrepancies.

Don’t trade on days with high volatility. If the markets have been experiencing wide daily swings — as they have been lately — avoid buying and selling ETFs altogether. Both the bid-ask spreads and the difference between NAV and market price can widen during volatile market days. If you’re adding money or rebalancing your portfolio, just wait until the markets are calmer.

Use limit orders. A limit order is an order to buy or sell an ETF only at a specified price or better. Buy setting the exact price at which you’re willing to buy or sell, you can avoid surprises caused by wide spreads or sudden price movements. Be aware that your limit order may be only partially filled, or may not be filled at all.

Don’t use stop-loss orders. Some people view stop-loss orders as a form of insurance: if an ETF’s price falls to the level you specify, a sale is triggered automatically and you’re protected for further losses. But think about how that would have worked last week. Had I placed a stop-loss order to sell XRE if it fell by 10%, that sale would have been triggered on May 6 and I would have liquidated my whole position. I’d have been left with a significant loss even after the ETF’s price normalized just minutes later. The best way for long-term investors to manage their risk is by setting an appropriate asset allocation, not by relying on a panic button.

Trade less. The keys to being a successful Couch Potato are choosing excellent ETFs (or index funds), building a well designed portfolio and only trading once or twice a year when you’re rebalancing. If you stay focused on the long-term you can ignore short-term market madness, even bizarre events like the “flash crash.”

Still, just to be safe, I’m moving my office to a windowless room on the ground floor.

Filed under: ETFs