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 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:
Look for a tight bid-ask spread. In theory, ETFs are all highly liquid: that is, you should be able to buy or sell units at prices very close to the fund’s net asset value (NAV), even if the ETF does not trade very often. But unpopular ETFs may be subject to wider did-ask spreads: this is the difference between what you pay for an ETF when you buy it (the ask price) and what you’ll receive when you sell (the bid). Ideally, this spread should be one or two cents. ETFs with high trading volumes usually have tighter spreads, but not always, so check before you enter your order.
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 you placed a stop-loss order to sell XRE if it fell by 10%, that sale would have been triggered on May 6 and you would have liquidated your whole position, even though 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.