With the popularity of ETFs1 on the rise, investors should be aware of how to trade them effectively. Unlike mutual funds, ETFs can be bought and sold on exchanges during market trading hours, similar to stocks. However, as ETFs derive their underlying value from a portfolio of securities, trading requires specific considerations that differ from buying and selling individual securities. Here are three important considerations when trading ETFs.
Tip 1: Consider Avoiding the Open and Close
The modern market structure has become increasingly fragmented and not all markets open up at exactly the same time in the US – therefore all stocks may not be available for buying/selling at the same time. Avoiding trades when the market opens may be beneficial when trading ETFs, as large trade imbalances can exist for certain underlying securities that can delay their opening as market makers2 work to find equilibrium pricing between buy and sell orders. Stock values may also rise or fall based on buyer/seller reactions to overnight news or earnings reports. The resulting price volatility of underlying securities directly impacts the price of ETFs that own those stocks.
Many market makers manage risk by widening their spreads and reducing their depth (or shares available to trade) in times of uncertainty, including at the market open. It may also be prudent to avoid trading at the market close, as market makers might not be willing to take on more risk at the end of the day. Remember, market makers ideally want to end each trading session with a flat book – an order book free of outstanding orders – due to the increased risk of carrying open positions overnight or over a weekend.
Tip 2: Be Aware of Different Types of Orders (Market Orders vs. Limit Orders)
Various types of orders can impact an investor’s trading outcome as they can send signals to the market. In ETF trading, two order types are particularly important: market orders and limit orders.
- Market Orders3 – the decision to buy or sell a security immediately at current market prices – demand liquidity at any price and prioritize speed of execution over price control. For most investors, the priority is just the opposite: price control over speed of execution. Market orders can expose an investor to price execution above net asset value, resulting in a premium paid for an ETF – especially when spreads4 are wide.
- Limit Orders5, on the other hand, set a desired price level and trades are only executed at a specified, or better, price. Using limit orders can protect an ETF order from an execution that differs significantly from the intrinsic value of the portfolio. Limit orders are especially important when purchasing an ETF with low trading volume. Market makers are normally willing to facilitate larger trades by accessing the liquidity of the underlying securities but may not show their entire depth on electronic trading platforms. By setting a marketable limit order (for example, close to the bid or ask), market makers can react to your order and provide the liquidity necessary.
- Limit orders may be at risk of not being filled completely if (1) the limit order is set too far away from the bid or ask, at an unreasonable price level; or (2) for structural reasons, the limit order would be only partially executed if the market price hits the stated limit and the trade is activated, but the market price never reverts to a favorable price.
- It may be advisable to avoid good 'til canceled (GTC) orders6 and utilize day orders7, as an investor should reassess the limit price on each new trading day.
When markets are volatile, there is a cost associated with demanding liquidity. Liquidity becomes scarce amid market stress – exactly when investors need it most. Most market participants are not obligated to make markets and will protect themselves in volatile times with wide spreads and thin markets8 (limited shares available to trade). The arbitrage opportunity that makes ETFs attractive can be impaired when market makers cannot assess the risk and the true intrinsic value of the underlying portfolio.
At times of market stress or dislocation, traders may want to step back and only trade when absolutely needed. If a trade is necessary, then investors should carefully compare the underlying portfolio to the ETF price and ask questions if something seems amiss before execution. Every ETF issuer has a Capital Markets desk that can explain the intricacies of their products and pricing methodology. Fully transparent ETFs allow investors to go look "under the hood" on a daily basis to fully understand the underlying securities and how the product is constructed. Semi-transparent ETFs, which active managers like Natixis utilize, enable investors to view actual portfolio intrinsic values and publicly available proxy portfolio holdings9 intraday.
During periods of heightened volatility, it is especially important to stick to a defined investment strategy to weather the storm. ETFs can serve as powerful tools over the long term to help investors meet their investment objectives and lead better financial lives.
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2 Market maker refers to a firm or individual who actively quotes two-sided markets in a particular security, providing bids and offers (known as asks) along with the market size of each. Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.
3 The term market order, or unrestricted order, refers to an investor buying or selling an investment immediately at the best available current price through a broker or brokerage service.
4 The spread is the difference between the quoted bid and ask price of a security or asset.
5 A limit order is an order placed with a broker or brokerage service to buy or sell a set amount of a financial instrument at a specified price or better. Unlike a market order, it may not be executed if the price set by the investor cannot be met during a certain time period.
6 The term good 'til canceled order (GTC) refers to an order to buy or sell a financial instrument at a specified price that is placed by an investor and remains active until it is either rescinded by the investor or the trade is executed.
7 The term day order refers to an order to buy or sell a financial instrument that expires at the end of each trading day.
8 The term arbitrage refers to the simultaneous purchase and sale of an asset on different markets with the aim of profiting on price differences between those markets.
9 A proxy portfolio for a semi-transparent ETF is designed to reflect the economic exposure and risk characteristics of the Fund's Actual Portfolio on any given trading day. Although the Proxy Portfolio and Proxy Portfolio Disclosures are intended to provide Authorized Participants and other market participants with enough information to allow them to engage in effective arbitrage transactions that will keep the market price of the Fund's shares trading at or close to the underlying NAV per share of the Fund, while at the same time enabling them to establish cost-effective hedging strategies to reduce risk, there is a risk that market prices will vary significantly from the underlying NAV of the Fund.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers, or any of its affiliates. There can be no assurance that developments will transpire as forecasted, and actual results may vary.
Investing involves risk, including the risk of loss. ETFs trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Diversification does not guarantee a profit or protect against a loss.
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Provided by Natixis Distribution, LLC, 888 Boylston St., Boston, MA 02199. Natixis Investment Managers includes all of the investment management and distribution entities affiliated with Natixis Distribution, LLC and Natixis Investment Managers S.A. Natixis Advisors, LLC provides advisory services through its division Natixis Investment Managers Solutions. Advisory services are generally provided with the assistance of model portfolio providers, some of which are affiliates of Natixis Investment Managers, LLC.