I have been looking at some of the new ETFs that have come out lately. One that looks interesting is the Claymore/Saprient Defender ETF (NYSE:DEF). This ETF is re-balanced quarterly and buys stocks that performed well on down days over the previous quarter.
But one big problem that I have with ETFs like this one is the relative lack of liquidity. Normally I buy small cap stocks in "chunks" of $20,000 at a time, but I like to buy mutual funds in "chunks" of at least $100,000. For open-end funds, there is no problem, since there is no bid-asked spread, and you get the NAV price at the market close. But for DEF, which recently traded at 25.35, I would want to buy around 5,000 shares at a time. It often trades with a spread of up to 4 cents which would be around $200 plus commission, and that can add up over time.
Of course, you could be patient and use a limit order to try to buy at the bid price or sell at the asked price. But I tried a small test trade of 1,000 shares and found that there is a big problem with "price improvement" trades of 0.0001 above or below the bid-asked.
“Price improvement” results when a wholesaler pays more for a stock than the current bid or asked price. This means that if a stock is being quoted at a $25.32 bid and a $25.36 ask and a customer wants to sell a stock at the market, the wholesaler can “price improve” their order and allow them to sell for $25.3201 instead of $25.32. The seller gets a miniscule price improvement of 10 cents on a 1,000 share order.
But the investors with limit orders to buy at $25.32 are really getting royally screwed. They are providing the wholesaler a free put option to sell his shares at $25.32 at a total risk of 0.0001!! If the stock goes up, they will not get executed. But if it drops significantly, the wholesaler will sell them their shares at a total risk to himself of only 0.0001. As a general rule it is a bad idea to give away free put options, and that is what a limit order is equivalent to here.
I have looked at the time and sales for DEF, and see many trades that were executed at prices like 25.3201 or 25.2699. Trades like this are a tipoff that investors using limit orders were taken advantage of. Unless this practice changes, I would recommend using only market orders for ETFs like DEF. For investors that buy small positions of a few hundred shares, this isn't too bad.
But for me, I will mainly use open end mutual funds instead of ETFs for my larger positions. The only exceptions would be ETF's like QQQQ, SPY and other highly liquid stocks that are heavily traded electronically. For ETF's like DEF which trade a low daily volume and trade on the Amex, you probably should use market orders, or very carefully track your limit orders to make sure you are not being taken advantage of by the ".0001 price improvement ripoff".