Rules of the trade

For financial advisors, lack of knowledge about trading ETFs can result in disadvantageous pricing that can erode one of the investment vehicle’s primary attributes – low cost.

The fact that ETFs are securities that trade throughout the day on an exchange – unlike mutual funds, which are priced at end of day at net asset value (NAV) – requires that advisors learn best trading practices to maximize returns for clients. Using specific trading orders when buying and selling ETFs is best. In addition, avoid trading at times of day when markets are less liquid.

“There’s a little bit of a learning curve in trading ETFs. It’s not complicated, but ETFs are different from mutual funds – and trading practices are important,” says Jaime Purvis, executive vice president, with Toronto-based Horizons ETFs Management (Canada) Inc. “With mutual funds, there’s no choice – you execute your order at NAV and can purchase or redeem only at the end of day. With ETFs, there is all-day trading and you can pick your point. The price is determined by the bid and ask spread around the NAV.”

With ETFs, a market-maker continuously matches the number of units outstanding in a particular ETF with baskets of all the securities held in that ETF’s underlying portfolio. Market-makers help determine the bid and ask prices for ETFs based on an assessment of the ETF’s underlying NAV. When the underlying securities are less liquid or difficult to trade for any reason, there may be wider than usual bid/ask spread for the underlying securities or no recent price from an actual trade. This may make accurate pricing of some of the underlying securities difficult for market-makers, and can result in the ETF itself showing a wider bid/ask spread at any given time in the day due to uncertainty about the ETF’s true NAV. The ETF may trade temporarily at a premium or a discount to the NAV of its underlying holdings, and this inefficient pricing can be disadvantageous to your clients.

Here are some tips on ETF trading best practices:

– Use limit orders – not market orders

A “limit” order sets a specific price for a trade – unlike a “market” order, which commonly is used when trading stocks and results in a trade being filled quickly at the current market price, according to a list of best trading practices created by PowerShares Canada, a division of Invesco Canada Ltd. of Toronto. Limit orders provide certainty on price and protect clients against overpaying or selling too low.

In setting a limit order, the closer your price is to the posted bid (if you’re selling) or ask (if you’re buying), the greater the chance that your trade will be executed quickly. The disadvantage of using a limit order is that the trade may not be executed at the stated price due to the lack of a match. And, in a fast-moving market, the price of an ETF can run away quickly from your limit order and leave you on the sidelines.

– Don’t trade near the market’s open and close

Prudence dictates that you avoid trading ETFs within the first and last 15 minutes of a trading day, the PowerShares Canada guidance states – as does strategy suggested by Toronto-based First Asset Investment Management Inc. Not all of the underlying securities in an ETF portfolio may begin trading within the first few minutes of a trading session, so market-makers may not be able to determine the ETF’s underlying NAV and thus price the ETF accurately.

Likewise, as the close of the trading day nears, market participation may dwindle, resulting in both fewer trades in the ETF’s underlying securities and fewer ETF market-makers posting prices. Therefore, the spread on ETF bid and ask prices tends to widen, making fair value harder to obtain.

– Watch for market volatility

Certain events can create market volatility, such as announcements by central banks, natural disasters and major corporate announcements. Volatility resulting from a surge or shortage of trades can lead to higher bid/ask spreads, thus eroding returns for clients due to inefficient pricing.

– Look at spreads, not volume

An ETF with substantial trading volume may appear to offer superior liquidity, but that is not the best measure, according to PowerShares Canada’s list of best practices. A narrow bid/ask spread is a better indicator of liquidity and efficient pricing relative to the ETF’s underlying NAV.

– Watch timing on international ETFs

Trading international ETFs during the trading hours of the underlying securities is preferable, whether they are stocks or bonds. Prices of international ETFs tend to be closer to the value of their underlying securities, with narrower bid/ask spreads, when their respective markets are open and overlap with Canadian trading hours.

“These simple trading practices are important, and we regularly review them with advisors and investors,” says Rohit Mehta, executive vice president of distribution and strategy at First Asset.