Exchange Traded Funds-Part 2: Trading Strategies to Avoid

In Part 1 of our Series on Exchange Traded Funds: How ETF's are Traded, we reviewed the process for how an ETF is traded in the stock market and the potential pricing distortions that can arise, especially when investing in foreign oriented funds. These distortions can have a material impact on how you invest and how much return you tangibly can bank from these products. In this segment, we review some strategies that you should avoid when you are about to click the buy or sell button  to invest in an ETF. Again, the good people at Krane Securities put together a really good checklist on these strategies to avoid.

Do Not: Trade within first half hour of trading:

Market makers need to know where an ETF’s underlying the stocks are trading to intelligently quote a bid and ask price spread. However many stocks do not open at the market’s open. Additionally market makers may want to understand the market’s tenor and vibe prior to quoting prices. While many market makers are unwilling to make a market at 9:30, there are market makers who will. Often times these prices are at very wide spreads (ie higher cost to trade). As a result, don’t just jump in and put your ETF order in right away. Let the market find its groove and wait an hour or so.

Do Not: Make Market On Close & Market On Open order types:

A specialist would “set” the closing price for stocks and closed end funds at the exchange. These order types allowed a specialist to balance their books by pairing off buyer and sellers. In ETFs the last trade is the closing price. ETF Market On Close orders can create an imbalance if there are more buys or sells which could cause an ETF to trade erratically higher or lower.

Do Not: Use Market Orders on Lower Volume ETFs

Market makers’ bid ask price spread contains how many shares they are willing to buy or sell. If a market maker is offering 1,000 shares on the offer, an investor looking to buy 100 shares could use a limit order to potentially get a better price. A market order might not benefit from the potential price improvement of using a limit order to “haggle” for a better price. Again these spreads are higher at the open of the market so best to wait for things to settle in before jumping on.

The Role of Volume & Expense Ratios in ETF Due Diligence

Bid ask spreads are a cost to investors. According to the Krane Report,

“If one had to choose between two ETFs identical in every way, one of cardinal rules in ETF investing would be to logically choose the higher volume and tighter bid-ask spread ETF. However ETF providers choose different indices in order to differentiate or improve upon existing ETFs. Do investors reward innovation or does their focus on expense ratios and volumes lead them to sub-optimal investments? Can one prove if investors are doing due diligence on ETFs? “

“The US large cap ETF category should show the smallest dispersion amongst all ETFs due to the efficiency of the underlying stocks. Looking at traditional market cap weighted indices in the category, neither the funds with the lowest expense ratios nor the highest volume ETFs are necessarily the best performing ETFs. The market cap and sector exposures create a disparity greater than the effect of expense ratios. While this analysis is done in hindsight it does beg the question to the extent investors are engaging in ETF due diligence. Investors appear to be sacrificing potential reward in exchange to own the “cheapest” ETF. Investors' desire to be thrifty over doing their homework appears to be a counter-productive endeavor. “

An Example: Calculating Trading Costs

“The aggregate costs for buying an ETF are expense ratio, bid ask spread, tracking error (how well did the ETF provider track their underlying index) and taxes generated by capital gains. While not forward looking, historic metrics can act as a guide for what might occur in the future. Utilizing the US large cap example, the best performing ETF in the category for the last five years had an expense ratio of 0.49%, average spread of 4.7 cents, tracking error of 0.66%, and generated no capital gains (Source: Bloomberg May 2014). With a share price of $37.02, 0.047/37.02 equals 0.12% incurred by buying the ETF on the offer. Conversely the largest ETF and least expensive ETFs had expense ratios of 0.09% and 0.04% with average spreads of 4.8 cents and 0.02 cents. While the highest volume ETF and least expensive ETF had lower costs, ultimately these costs were negated by the performance of the fund's holdings. “

The takeaway for me is that one branded S&P 500 ETF is not the same as another branded S&P 500 ETF. They may be attempting to mirror the same index but the approaches and costs associated with them may be different. As investors, you have to spend some time to read the fine print and prospectus to really understand what you are investing. ETF’s are not simple investment vehicles anymore. They just are not your daddy’s ETF’s anymore. Were just talking about basic index based ETF’s. It’s even worse when you start looking at geographic or managed-based ETF’s. Furthermore, an ETF prospectus is not an easy read. They are much more technical than reading the financial statements of a company like McDonalds. At least I know what I’m investing

The good news according to Krane is that, ” On a daily basis newspapers and financial websites publish securities that experienced large increases in volume from their historic average. ETFs tend to dominate the volume movers table. This proves the effectiveness of the creation/redemption process. It also proves there are investors engaging in ETF due diligence. Armed with the proper information, the informed ETF investor can make judicious investment decisions.”