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.

11 Responses to Tips for Trading ETFs

  1. Canadian Capitalist May 18, 2010 at 12:02 pm #

    Stop loss orders are especially scary for ETF investors. If an investor had put a stop loss on VTI, it may have been sold at 50% below (or worse, though some of the egregious trades were reversed) the day’s closing price. VTI more or less bounced back in an hour or two but an investor who sold is looking at a huge capital loss.

  2. NeoCyber May 25, 2010 at 3:25 pm #

    Hi there,

    If I may add, you can perform stop losses ‘with limit’. So in other words, “if the share price drops to $10, create a market sell order at $10”

    A regular stop loss becomes “if the share price drops to $10, sell at market”

    At least two discount brokerages I know of have this option…

  3. Canadian Couch Potato May 25, 2010 at 5:46 pm #

    NeoCyber: Stop limit orders would prevent complete catastrophe, but on May 6 they would still have locked in losses that corrected themselves in minutes.

  4. Jason August 4, 2010 at 11:30 am #

    Dan, once again thank you for all your information. I have a question with regards to purchasing ETFs. A lot of the site is dedicated to buying ETFs and I am hoping to make my transition to these from mutual funds in the future. However I have no experience buying stocks. This article really caught my eye because I had never taken into account that there will be special considerations when purchasing the ETFs (and I probably should have realized this since I know you buy and sell them like a stock!).

    For example I see from your post here that purchasing close to the “NAV” is a good idea. Could you help me break it down on how one would proceed to buy an ETF based on this? Is the NAV value only on the ETF providers website or can it be found in the research area of a discount brokerage? Does one look up this value for the previous day, then put in a buy limit based on this value? For simplicity, do you just put the buy limit as the NAV or do you try to get the price lower by putting the buy limit a bit lower?

    I found this PDF from ishares; but it may have made things even more complex in my mind 🙂

    http://us.ishares.com/content/stream.jsp?url=/content/en_us/repository/resource/valuation_terms.pdf&mimeType=application/pdf

    Thanks a lot,
    Jason

  5. Canadian Couch Potato August 8, 2010 at 10:24 pm #

    @Jason: Great questions. Only previous days’ closing NAVs are available on the ETF providers’ websites. Discount brokerages will only show the market price. So during the day there is no way that I know of to compare the two simultaneously.

    However, the important point here is that if you’re thinking about buying a specific ETF, you should watch the website for several days and see how closely its market price is to its NAV over several days or weeks. (Both Claymore and iShares have NAV histories on their sites.) In big well-run ETFs, the difference will rarely be more than a cent or two. But thinly-traded ETFs sometimes trade at substantial premiums for days on end. If that’s the case, you might consider using a limit order or just finding another ETF that is more liquid.

    Hope that helps.

  6. Jason August 10, 2010 at 9:50 am #

    @Canadian Couch Potato

    Thanks for the information! That helps a lot. Thank you for taking the time to respond to my questions.

    Jason

  7. ABC September 14, 2010 at 11:39 am #

    In response to a comment above the CCP writes, on August 8, 2010, 10:24 pm:

    “Only previous days’ closing NAVs are available on the ETF providers’ websites. Discount brokerages will only show the market price. So during the day there is no way that I know of to compare the two simultaneously.”

    I called iShares and the fellow I talked to explained that the NAV is only established at the end of the trading day. So indeed it does not seem possible to compare the NAV with the trading value in an on-going manner while the ETF is trading.

    However TD Waterhouse WebBroker makes some info available to the general public which may be useful to investors. When looking for information on a specific ETF you can find: the latest NAV available, also the trading premium or discount based on the previous day closing price.

    See an example with XIC inside the Market and Research section by simply entering XIC in the upper right window under “Symbol Lookup” at:
    https://www.tdwaterhouse.ca/markets/index.jsp?referer=https://www.tdcanadatrust.com/markets/index.jsp

    Here’s some info that was available on the date I looked it up:

    XIC:

    Holding Details
    Total Net Assets $1.1B
    Shares Out. 55.4M
    Net Asset Value (NAV) $18.49
    Prem/Discount to NAV -0.03%
    P/E Ratio 17.0
    Dividend Yield 2.46%
    Div/Share $0.46
    Expected Div Date 06/25/2010
    Next Dividend Payment Date 09/25/2010
    Beta 0.97

    It shows the previous closing price in the horizontal portion of the screen.

  8. Que January 30, 2013 at 6:38 pm #

    @Dan,
    You say, “If you’re buying an ETF that holds European stocks, consider making your trade between 10 and 10:30 am EST”. Do you usually follow this rule when trading VXUS, as I imagine there isn’t a perfect time to purchase that ETF?
    Thanks, Que

  9. Canadian Couch Potato January 30, 2013 at 11:52 pm #

    @Que: You’re right, VXUS holds a lot of stocks in Asian countries, and there are no times when the Asian and North American markets are both open. I have never had difficulty trading this ETF at any hour.

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