A panel of market makers of exchange-traded funds (ETFs) unanimously cautioned investors against using market orders to trade ETFs at an ETF conference in Toronto Monday. Instead, they suggested that investors, traders, and advisors use limit orders when trading ETFs, to avoid being dinged by the extra costs that may result from a wide gap between bid and ask prices in the ETF market.
Market orders are an order to buy or sell a security at the current price in the market based on supply and demand, but the market price can fluctuate quickly. A limit order sets the exact price the buyer or seller is willing to accept, and if the ETF is not available at this price, it won’t be purchased or sold by the client.
“Never use a market order,” Kevin Fong, Toronto-based managing director at BMO Capital Markets, told the Exchange Traded Forum, sponsored by Radius Financial Education. “It’s better to pick a price you’re comfortable doing the trade at. You need to put limits on it. Otherwise you can end up paying too much.”
Market makers create a stable market for ETFs and establish their price, which is based on the trading price of the ETF’s underlying securities. But liquidity issues in these underlying securities can sometimes result in pricing delays in the market, and affect the prices for the actual ETF. An imbalance of buyers and sellers for the actual ETF can also impede liquidity and widen spreads between bid and ask prices, resulting in higher costs for investors. Fong also said if a market order comes through when the market maker is in the process of resetting prices, getting caught in the gap may not work in the client’s favor.
“Take a look at the trading, see what the recent trade, and bid and ask prices are, and pick a reasonable price,” said fellow panelist Ed Boyd, managing director at RBC Capital Markets in Toronto.
However, it’s important with any limit orders to not be too far off the current bid or ask, or the ETF is less likely to trade.
Next: Avoid trading at market opening
Avoid trading at market opening
The market makers warned it’s usually best not to trade ETFs within the first 15 minutes or so after the market opens. At this time, market makers are waiting for prices to be established for the underlying securities of the ETFs. If market makers have to make an estimate on the value of any of the underlying securities tied to an ETF, they are likely to guess high, which would increase the cost for investors, Fong said.
“Unless there is a real urgency, I would wait until after the first 15 minutes of the market opening,” Fong said. “The spreads can be wide at the beginning of trading. It’s better to wait until everyone is in the market, otherwise you may be paying a premium.”
Another panelist, Reggie Browne, senior managing director and global co-head of the ETF Group at Cantor Fitzgerald & Co. in New York, said that although ETFs may appear simple, they are not.
“If you break ETFs apart, they are complex,” Browne said.
The complexity of ETFs increases in emerging markets, he said.
“There are a lot of inputs that need to be assessed, including tax issues, foreign exchange and liquidity,” Browne said. “A trader needs to know about all the inputs.”