3 Ways to Get the Best ETF Executions

09/26/2013 9:00 am EST

Focus: STRATEGIES

Dave Paterson

Founder, D.A. Paterson & Associates Inc.

One of the great features of ETFs is that unlike mutual funds, which are priced once per day, you can buy or sell an ETF anytime during the trading day. But there are drawbacks, cautions Dave Paterson in Building Wealth.

One unfortunate drawback is that sometimes the market price may be higher or lower than the Net Asset Value (NAV) of the underlying basket of securities.

When the market price is higher than the NAV, it is trading at a premium, and when it is below the NAV, it is trading at a discount.

There are a number of reasons that premiums and discounts happen. One reason is the ETF has low trading volume.

When this happens you may see fairly large spreads between the bid price, which is the price at which somebody is willing to buy the ETF, and the ask price, which is the price at which somebody is willing to sell the ETF.

Another reason this could occur is that the underlying securities in the ETF are not very liquid and do not trade very often.

In most cases, when pricing an ETF, each of the underlying securities are priced at their last traded price. Where the underlying securities don't trade very often, the prices used to calculate the NAV can be out of date, and not reflective of the current value.

This is more likely to happen in very specialized ETFs, or in fixed-income ETFs, where bonds trade over the counter. When this happens, it is the market value that is often a more accurate reflection of the true value.

A third reason that a premium or discount can occur is with ETFs that have significant holdings in European or Asian equities. Like with the case of an ETF that holds illiquid securities, the prices used to calculate the NAV of international ETFs may be out of date.

This is because these markets are often closed when the North American markets are open. In these situations, assuming you are looking at a large-cap focused ETF, it is very likely that the market price is more reflective of the out of date NAV.

There are ways you can protect against these potential pricing issues. Three of the main ones include:

  • 1. Use limit orders—A limit order is one where you specify the price at which you want to buy or sell a security on an exchange. With an ETF trade, pick a price that you feel is indicative of the true value of the ETF, and use that as your limit. This price will typically be between the bid and ask prices.

  • 2. Avoid trading in the opening or closing minutes of the day—Because these periods tend to be the most active trading times of the day, it may be more difficult for the NAV to be reflective of the price. By trading in periods where things are calmer, it is much more likely that the market price will be much closer to the NAV.

  • 3. Trade International ETFs early in the day—Given that price discrepancies are generally larger when markets are closed, you will want to buy or sell international ETFs while the international markets are still open for trading. Unfortunately, Asian markets are closed well before North American markets open, but European markets are open until 11:30 EST. If you can, try to place orders for international ETFs between 10:00 AM and 11:00 AM EST.

Bottom Line: The ability to buy and sell ETFs at any point during the day is one of their more attractive features. It can also be a source of short-term price distortions. By talking some basic precautions, the likelihood of being hurt by any of these price distortions can be minimized.

Learn more about this financial newsletter at Building Wealth….

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