In this multi-part series, I present to you what I have learned from my research into the workings of ETFs and ETNs, both of which fall into the category of exchange-traded products [ETPs]. This series is geared more towards beginner and intermediate investors, but I hope that there will be a bit of something for everyone. To my knowledge, no such series regarding ETPs has been previously published on Seeking Alpha. To understand the inspiration of this series, please refer to the first article.
Part 2: Buying and Selling ETPs
The second part of this series discusses the buying and selling of ETPs on the secondary market. Since ETPs trade on national securities exchanges just like stocks, you can use the regular order types just as you would when buying or selling ordinary stocks.
Best practices for trading ETPs
According to Vanguard, the #2 ETF provider as ranked by assets under management [AUM], there are 7 "best practices" for ETF trading, which should also be applicable to ETNs. Salient points from their presentation are summarized below:
1. In general, use marketable limit orders instead of market orders.
A marketable limit order is a buy limit order that is placed at or above the ask price, or a sell limit order that is placed at or below the bid price. This ensures that your trade will be executed at your desired level, with only a mild dropoff in execution probability.
2. A block trading desk can help tackle a large trade.
For very large trades, contacting a block trading desk of a brokerage firm can lead to improved execution outcomes, although this is probably not pertinent for most retail investors.
3. Beware of the open and close.
At the market open, not all of an ETF's constituents may have started trading, making it more difficult to price the ETF accurately. Similarly, as market close nears, an ETF may experience wider spreads and more volatility as market participants begin to limit their risk, leading to fewer firms "making markets" in an ETF.
4. Pay attention during volatile periods.
During volatile periods, the prices of an ETF's constituents may move wildly, large premiums and discounts or wider spreads. Extreme caution should be taken if using market orders under these conditions. Conversely, premiums and discounts can lead to opportunistic arbitrage opportunities (see below).
5. Tune out the volume.
An ETF's bid-ask spread may provide a better indication of liquidity, compared to average daily volume (ADV), because it incorporates the liquidity of an ETF's constituents and the associated costs for authorized participants (APs) to engage in the creation/redemption process.
6. For trading international ETFs, it's a matter of time.
In general, it is better to trade U.S.-listed international ETFs during the times that the local markets are open, as during these times the prices of the international ETFs are more closely matched with the values of the underlying constituents.
7. When in doubt, call for help.
Most retail brokers have customer service facilities that are available in case an investor has questions about trading ETPs. ETP issuers themselves may also be approached in the case of specific questions about a particular product.
What's the difference between trading mutual funds and ETFs?
Given that many investors, particularly those in the older generation, were first introduced to ETFs as alternatives to the more established mutual funds (including index funds), it is worthwhile to refresh ourselves on some of the differences between mutual funds and ETFs.
|Trading and pricing||ETFs trades intraday on the major stock exchanges. Their prices will fluctuate throughout the day just like stocks.||Mutual fund shares are priced once a day after the markets close.|
|Transaction costs|| |
Investors pay a standard brokerage fee for trading ETFs, just like stocks. (*Some brokerages offer commission-free ETFs).
Each transaction also involves paying the cost of the bid-ask spread, which can be significant for illiquid ETFs.
Investors may pay a front-end or back-end load when buying or selling a mutual fund, respectively. Some funds are no-load funds.
Mutual funds do not have bid-ask spreads.
|Minimum investment amount||As little as 1 share of an ETF can be purchased.||Mutual funds generally have minimum investment amounts.|
|Options||Options are available for actively-traded ETFs.||Options are not available.|
|Dividend reinvesting||Nearly all ETFs pay out their dividends as cash, requiring the investor to manually reinvest the money.||Many mutual funds ("accumulation" class) automatically reinvest dividends into the same fund. "Income" class funds distribute cash.|
With some of the more basic aspects out of the way, what are some of the investment takeaways that an investor may find useful when considering buying or selling ETPs?
1. Take advantage of commission-free ETFs
Many brokerages offer commission-free trading in selected line-ups of ETFs. The commission-free ETFs offered by some of the major retail stock brokerage houses are shown below:
- E*Trade (NASDAQ:ETFC): Global X ETFs, Deutsche Bank ETFs, WisdomTree ETFs
- Fidelity: Fidelity ETFs, iShares ETFs
- Interactive Brokers (NASDAQ:IBKR): Global X ETFs, Cambria ETFs
- Schwab (NYSE:SCHW): Charles Schwab ETFs, Global X ETFs, SPDR ETFs, PowerShares ETFs, WisdomTree ETFs, and 11 others
- TD Ameritrade (NASDAQ:AMTD): iShares ETFs, SPDR ETFs, Vanguard ETFs, and 5 others
- Vanguard: Vanguard ETFs
Some brokers, such as Scottrade, do not have any commission-free ETFs in their line-up, as far as I know.
While a few dollars of commissions here and there probably won't break the portfolio of investors in the mid-to-late stage of their careers or those who are comfortably retired, it can really add up for younger investors who are just starting out.
For example, let's take the average 25-year old ("Joe") who earns the median U.S. income for his age of about $28,000, paid bi-weekly. Unlike many of his fellow millennials, Joe is relatively diligent with his saving habits and resolves to put aside 10% of his gross salary into the stock market. He has also been convinced by the merits of the dollar-cost averaging [DCA] approach, which he plans to put into action. He therefore opens an account at Fidelity and puts 10% of each paycheck into two ETFs (one stock fund and one bond fund). Question: how much his total investment will be eaten by commissions?
The answer, using Fidelity's standard commission of $7.95 per stock trade, is a whopping 14%!
The morale of the story is clear (and hopefully obvious): if your brokerage has commission-free ETFs, take advantage of it!
2. Use (marketable) limit orders especially in times of volatility
This is also included in Vanguard's 7 best practices, but I thought I would re-emphasize this here.
I think everyone remembers the Aug. 24 "flash crash" last year, where all stocks appeared to crash simultaneously at the open, followed by a quick recovery. For very liquid ETFs like the SPDR S&P 500 ETF (NYSEARCA:SPY), the low point reached was about 6.6% off from its closing value that day.
How about the First Trust Dorsey Wright Focus 5 ETF (NASDAQ:FV)? This ETF is less popular than SPY, obviously, but not exactly illiquid (it has an average trading volume of 1.7M according to Morningstar). Its low was a stunning 47% off its final closing value that day.
As FV is actually an ETF of ETFs, I suspect that market makers were having an incredibly difficult time pricing FV accurately under the extreme conditions at the time, given the multiple levels of stock ownership involved. Hence, anyone using a market order to sell FV in the early minutes of Black Monday would have sold their ETF at an exceptionally large discount to its net asset value, such as the person who took the opposite side of my trade that morning:
15% profit in less than 1 hour, I'll take it! Of course, my buys were nowhere near the low of that day. I would have bought FV earlier, and in much greater quantity as well, had I not been dazed by the sea of red washing over my account!
Other aspects pertinent to buying and selling ETPs, such as fees, tax considerations, and being aware of the differences between ETFs and ETNs, will be considered in future parts of this series.
Do you have any "best practices" for trading ETPs? Does your choice of broker affect the ETFs that you trade, or vice versa? Feel free to share in the comments section below!
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.