Trade ETFs Like THIS, Not THAT

Trade ETFs Like THIS, Not THAT

3.5 MIN READ 

Exchange-Traded Funds (ETFs) have existed as we know them since 1993, when State Street Global Advisors launched the S&P 500 Trust ETF (SPY), still one of the most widely traded ETFs today.

According to the Investment Company Institute website, there was roughly $3.6 Trillion of total ETF AUM as of March 30, 2020. Despite their widespread adoption and given the vast array of tools that facilitate portfolio rebalancing for investors and advisors, there are still many potential pitfalls when executing ETF trades that we would like to help you avoid. 

With the goal of providing the best outcomes possible, we have created a collection of ETF trading do’s and don’ts. And while we understand it can be impractical or impossible to follow all of them all of the time, implementing as many as you can may lead to more optimal results for your clients. For advisors who do not have the capacity to account for all of these suggestions, outsourcing your trading operations or using open-end mutual funds may be prudent and effective ways to implement client portfolios.

DON’T select ETFs simply based on one characteristic such as the exposure they provide (e.g. the index/sector/factor they track) or the reputation of its sponsor / manager alone.
  • DO select ETFs that provide the best aggregate of factors including exposure, implicit and explicit costs, reputation of the sponsor, among others.
  • DO select ETFs that exhibit low and stable spreads and discount/premiums versus peers whenever possible. There are several contributing factors including trading volume, ETF size, and the liquidity of the underlying securities, but these factors should not be considered alone.

DON’T trade at the open or close of day. At the open, especially on Mondays, markets are digesting overnight (or the weekend’s) news into prices, so volatility can be elevated. Also, some of the underlying securities may not have begun trading yet. At the end of the trading day, market makers may begin to limit their risk. Either scenario can lead to wider spreads and less-advantageous conditions for the ETF investor.

DON’T place a trade when the market the ETF trades on is closed. This is common with underlying securities traded in global exchanges. Your order will be executed upon market open. See above regarding trading at the open.

  • DO try to trade ETFs between 10am – 2pm ET as a general rule. For ETFs holding non-US stocks, earlier in that window is better because some global stock exchanges may still be open. Prices of ETFs more closely align with that of their underlying securities, and spreads tend to be narrower, when the markets of both the ETF and underlying securities are both open. Note that this does not mean the ETF price is incorrect, as it may more accurately reflect the market’s sentiment.
  • Related to that, DO be aware of days when the US stock market is open but the US bond market is closed when trading bond ETFs. This can result in price dislocation because the ETF will trade on the stock exchange while the underlying bonds will not be trading. For example, the NASDAQ and NYSE stock exchanges are open on Veteran’s Day and Columbus Day observances, but the bond market is closed on these days.

DON’T trade around major Federal Reserve Board announcements or meeting dates, earnings announcements by large constituents of the ETF, or other important news that can lead to volatility.

DON’T trade on particularly volatile days if you can help it.

DON’T trade on benchmark reconstitution or rebalancing dates.

  • DO perform a sanity check when trading a specific ETF. For example, if the ETF you are buying or selling is up 5% but its index is down 1%, it may be a signal that something is awry.

DON’T blindly use market orders unless guaranteed execution is more important than the price received for the trade.

  • DO use limit orders instead when practical, or more specifically we suggest a marketable limit order, in which you enter your price at or above the best ask/offer for buys and at or below the best bid for sells. A common practice is to enter your price one penny above the ask or one penny below the bid. Your custodian may attempt to get you an even better price (called “price improvement”), but we would not advise complete reliance on that. Note: this is one area where it may be operationally impractical depending on how much of a delay there is in your quote system, whether you use a rebalancing software, among other factors. An expert trader or outsourced trading service may be able to get around this recommendation using other techniques.
  • DO be aware of potential price changes when trading ETFs and mutual funds in the same rebalancing trades. For example, the ETF order will be executed intra-day, while the mutual fund will not be priced until 4PM ET; market movements in the interim can affect the end result. Each custodian is different about how these trades should be handled.
  • DO be aware of entering similar trades for different clients at different times to ensure none appear to have been favored or disadvantaged. Blocking orders or trading all accounts at the same time of the day can mitigate this risk.
  • DO contact your custodial trading desk for large orders. The definition of “large” is subjective, but anecdotally the custodians we are most familiar with consider >2% of daily volume to be a large trade. A brief call to your trade desk is worth it whenever you are unsure, because they can work with the ETF issuer or market makers directly, and/or have access to other avenues for execution.

Mario NardoneAbout the Author
Mario Nardone, CFA, is the Chief Investment Strategist for XY Investment Solutions and the President & Founder of East Bay Financial Services. He began his investment career in 1999 with Vanguard mutual funds in Valley Forge, PA, where he consulted institutions and financial advisors on investment policy, portfolio construction, and Exchange-Traded Funds (ETFs). He also contributed to the research and publication of the firm's world-renowned investment philosophy and served as a municipal bond fund specialist, among other roles during his tenure.

In 2003 he earned the Chartered Financial Analyst designation, widely regarded as the highest standard in the investment profession, and he continues to mentor aspiring Charter candidates in its curriculum, ethics, and career opportunities. Mario relocated to Charleston in 2010 to serve as Chief Investment Officer and Chief Compliance Officer for a respected financial planning and advisory firm in Mount Pleasant before establishing East Bay Financial Services, the collaborative partner firm of XY Investment Solutions. Mario is Past President and of CFA Society South Carolina and Former Chairman of the College of Charleston Finance Department Advisory Board.

His approach to investments and the industry has been featured in Investment News, NAPFA Advisor Magazine, and other regional and local publications. Mario is active in recreational sports and the Charleston community, and is a member of the Historic Middleton Place Foundation. He is an avid traveler and SCUBA diver, and enjoys spending time with his wife, Piper, and their "energetic" lab/shepherd mix, Cady.

 

Sources

  1. Exchange issue affects quarter-end prices of 3 Vanguard ETFs. Vanguard April 2, 2015
  2. Fixed Income ETF Premiums and Discounts. State Street Global Advisors. March 18, 2020
  3. Debunking myths about ETF liquidity.  JP Morgan. May 2015
  4. Understanding ETF liquidity and trading.  Vanguard
  5. ‘Best practices’ for ETF trading: Seven rules of the road. Dickson, Joel D. & Rowley, James J., June 2014
  6. What Days Are U.S. Stock Exchanges Closed? Phung, Albert on Investopedia. April 7, 2020

Disclosures

East Bay Financial Services, LLC, a Registered Investment Advisory firm, supplies investment research services under contract.

This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services.  This document does not constitute tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein.  This document is intended for the exclusive use of East Bay clients, and/or clients or prospective clients of the advisory firm for whom this analysis was prepared in conjunction with the EAST BAY TERMS OF USE, supplied under separate cover.  Content is privileged and confidential.  Information has been obtained by a variety of sources believed to be reliable though not independently verified.  To the extent capital markets assumptions or projections are used, actual returns, volatility measures, correlation, and other statistics used will differ from assumptions.  Historical and forecasted information does not include advisory fees, transaction fees, custody fees, taxes or any other expenses associated with investable products unless otherwise noted.  Actual expenses will detract from performance.  Past performance does not indicate future performance.

The sole purpose of this document is to inform, and it is not intended to be an offer or solicitation to purchase or sell any security, or investment or service.  Investments mentioned in this document may not be suitable for investors. Before making any investment, each investor should carefully consider the risks associated with the investment and make a determination based on the investor’s own particular circumstances, that the investment is consistent with the investor’s investment objectives.  Information in this document was prepared by East Bay Financial Services, LLC. Although information in this document has been obtained from sources believed to be reliable, East Bay Financial Services, LLC does not guarantee its accuracy, completeness, or reliability and are not responsible or liable for any direct, indirect or consequential losses from its use.  Any such information may be incomplete or condensed and is subject to change without notice.

Visit eastbayfs.com for more information regarding East Bay Financial Services, LLC.

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