Timely Insight for Trading ETFs More Effectively

by: Don Dion

The advent of electronic trading and the increased accessibility of trading platforms have made the purchase and sale of ETFs more readily available to individual investors. ETFs, which have the unique qualities of both stocks and index funds during intraday trading, have an added level of transparency that has made a whole new generation of investors more comfortable trading in the open market. At the same time, the sudden influx of new ETFs into the market has led to problems for beginner traders. Some of the new ETFs have attracted the funds and investor enthusiasm necessary to thrive over the long term, but other products have failed to pick up steam and have traded at sharp premiums or discounts to their actual value or folded entirely. While no trading strategy is foolproof, by taking into account factors like net asset value, liquidity, order type and time of day, beginning ETF traders can avoid some of the pitfalls common to the marketplace.

The most important characteristic of ETFs, which differentiates exchange-traded funds from stocks, is the availability of the fund’s net asset value (NAV). Most ETFs are composed of a basket of securities, which have individual prices at any moment during their regular trading hours. Since the value of the underlying securities can be determined, the value of the ETF itself, or NAV, can be calculated. If an ETF is trading for less than NAV, it is “trading at a discount,” and if it is trading for higher than NAV, it is “trading at a premium.” Understanding premiums and discounts is important for traders who want to get their money’s worth when buying and selling funds.

To compare the current price of an ETF to its NAV, chart the symbol versus its “Intraday Indicative Value,” or “IIV.” The symbol of an ETF’s IIV is usually simply the original symbol plus “.IV”. For example, to chart the IIV of the iShares Russell 3000 Value Index Fund (IWW), you would enter “IWW.IV” into your trading platform. Most fund sponsors also offer the opening and closing prices of the ETFs, along with their actual NAVs on their websites, offering investors a unique opportunity to observe trends over time.

In addition to letting you know if you are “paying up” or getting a discount on the fund’s underlying assets, historical charting of these patterns can tell you a great deal about the health of the fund and how it trades. Many of the fund websites, such as iShares.com or Powershares.com, offer premium and discount charts, while ETFconnect.com is a good independent source for most funds. By looking at historical patterns, investors can observe whether an ETF is trading in line with its historical tendencies. If an ETF generally trades at a premium to NAV and is suddenly trading at a steep discount, investors can draw conclusions about whether the fund is over- or undervalued.

The presence or absence of premiums and discounts is also related to—and is often a consequence of—fund liquidity. Very liquid ETFs, ones that have average trading volumes in the millions, tend to trade close to their NAVs. Because there is abundant investor interest in their products, market makers and traders alike stand ready to buy and sell such an ETF close to its actual value during the trading day. In illiquid products, those in which only a few thousand shares change hands during a day, it is often difficult to find a buyer or seller for your desired purchase. Even appointed market makers are only required to provide liquidity at a certain spread and quantity, so investors in illiquid funds often end up buying ETFs for large premiums; they then have to sell them at marked discounts when trying to unload their shares.

One solution to the liquidity and value problem is for investors to seek out ETFs that trade the largest number of shares on an average day. Often, more than one fund company will offer similarly themed ETFs. When selecting a themed fund, like “emerging markets” or “gold,” it is advisable to seek out all the available ETFs in that category and compare average trading volumes. Relatively higher trading volumes indicate a higher likelihood that you will be able to buy and sell the stock for what it’s worth and also that the ETF is less likely to close up shop due to a lack of investor interest.

Sometimes, however, investors seeking a unique approach for their portfolios will need to buy and sell shares of less liquid ETFs. If this is the case, it is advisable to consider different order types when placing your buy or sell order. “Market orders,” which simply execute at the next available bid or offer, are relatively safe in large liquid funds but can result in large premiums and discounts in smaller illiquid funds. More-patient investors should instead try to place limit orders as close to NAV as possible to get fair prices on their trades. Limit orders allow the traders to pick a price at which they would be willing to buy or sell shares. If there is counterparty interest at your chosen price, the trade will execute, but unlike market orders, this execution is not a guarantee.

Despite increased electronic trading and less human interference in the pricing process, trading is still an emotional and irrational process for many. With ETFs, there is less of an excuse to buy high and sell low, because it is possible to determine—at all times—what the underlying value of the ETF is. While delays in trading data still make it difficult for individual investors to guarantee price execution at NAV, certain considerations such as liquidity and order type can significantly improve execution price. As decreased human intervention and increased access to the markets make it easier for individual investors to participate in trading, these investors must also assume an increased level of accountability when buying and selling shares.