The tips and traps of trading ETFs

Exchange-traded funds are gaining traction with retail investors in Australia for some very good reasons: they offer instant diversification, the fees are low and international markets can be bought without any fuss.

Thousands of stocks and bonds can be bought with only a few trades.

There doesn’t seem to be any argument that ETFs are an effective tool to reduce risk in a portfolio. Any investor guilty of concentrating their risk on certain companies or sectors will know what can happen when markets do not agree with their forecasts. There isn’t any better method of reducing risk than diversifying among asset classes and investments.

But ETFs are still relatively misunderstood. Some would argue that active management of an equities fund is always a better bet. Why hold the entire ASX200 index, they might say, when half the constituent companies can be certain to underperform? Surely any active manager can beat the index. Well, often they can’t. But let’s leave that for another story.

The fact is the rise of ETFs has delivered investors powerful new tools, but it’s important to understand how these units are constructed so that the experience of trading them doesn’t throw up any surprises. Here are some tips. 

THE SPREAD

ETFs trade in units which are created and redeemed by providers to meet demand if it can’t be met in the secondary market. Anyone who has bought or sold highly liquid stocks, such as any of the top 20 companies on the ASX ranked by market capitalisation, will be familiar with orders placed “at market” being transacted almost instantaneously. “Limit” orders, where the buyer or seller sets a bid or offer price, may take longer to attract interest.

When traders of stocks look at the market depth for ETFs for the first time, they notice pretty quickly that sometimes there is barely any trading activity. The “illiquid” nature of the market for ETFs relative to equities is a bit of a mirage, however, because those same traders will notice large orders waiting in the margins, making up the spread. These large orders have been placed by market makers, who have agreements with ETF providers to provide liquidity when it’s needed.

If the retail investor places a sell order close enough to the net asset value (NAV) of the underlying securities in the ETF, the market maker will let it sit there until a buyer pops up. If the seller loses patience, he can set the price closer to the market maker’s highest offer. The market maker may take the bait if it senses an arbitrage opportunity. If the seller wants to transact quickly he can set the offer price equivalent to the offer.

Market makers’ bids and offers are often of equivalent unit amounts are should be pretty easy to recognise. They will usually be a large round number.

CHECK FOR PRICE DISPARITY

Other than looking at the market depth and the bid-offer spread, retail investors can also turn to the ETFs providers for an estimate of the NAV for an ETF. Be aware the stats published on a website or in a factsheet may not be up-to-the-minute, especially when the underlying investments are traded in offshore markets. If you think the NAV is outside the bid-offer spread, give the ETF provider a call. There may be a reason the spread looks too wide. If there isn’t a reason, the ETF provider might feel compelled to get onto the market maker to find out what’s up.

ALWAYS USE LIMIT ORDERS

Market makers are as opportunistic as anyone else in the investment world and if a novice retail investor places an “at market” order when there are no buyers or sellers in the secondary market the market maker will happily step in to complete the trade. The market maker has one eye keenly focused on the NAV for the ETF unit and has set bid and offer orders to ensure a profit should it need to enter the market.

That is why retail investors should always use “limit” orders when trading ETFs, although it may require a bit more patience. Anyone who places orders “at market” will have to accept they have forfeited some profit from the get-go.

BE AWARE WHEN OFFSHORE MARKETS ARE CLOSED

Obviously market makers are as prone to some risks as anyone else, such as when they are trading units of ETFs over offshore indices that are closed when the ASX is open. When those markets open again, for whatever reason prices can be substantially lower. The market maker has to reset NAVs for the ETFs it oversees at the close of trade and then adjust its bids and offers in our market.

For Australian retail investors, the risk is that they may be trading a proxy for an offshore index precisely when there is no market in the underlying securities (apart from futures). The market could open at a much higher or lower level. Retail investors have no defence against this, but it’s reason enough for them to consider ETFs more as medium- to long-term investments. It’s crazy for anyone to think they can day-trade global ETFs on the ASX when the constituent markets are closed.

AVOID OPEN AND CLOSE

The role of market makers can’t be underestimated in Australia as the retail ETF market is still small — about $20 billion compared with more than $500 billion in managed funds. As market makers with contracts over global ETFs gear up each morning before the ASX opens they have to reprice units based on the latest data from offshore. For whatever reasons, retail investors are advised to avoid trading within about 30 minutes of the market’s open or close. It is the ETF providers themselves who recommend this strategy. As it is the market makers who stand to profit from price mismatches, and not the ETF providers, it makes sense to follow the providers’ tips.

CONDITIONAL ORDERS

The use of conditional orders, such as a “stop loss”, is not straight-forward with ETFs. We know that the bid-offer spread can be distorted near open and close, and that the NAV used by market makers of international ETFs may not be even close to how the foreign markets price the underlying assets when they open. Recent volatility in the US and Chinese markets saw the prices of some ETFs gap substantially lower than NAV, and the presence of opportunistic market makers meant preset stop loss orders were triggered. The same thing hasn’t happened here, but investors shouldn’t tempt fate.

EAST TO GET RIGHT

It seems that with ETFs anyone can sit down at a laptop and rustle up a reasonable portfolio with as little as five or so investments, including major global indices, the local equities market, government and corporate credit here and around the world and a cash strategy that goes well beyond a restrictive term deposit.

Working out ideal weightings and rebalancing allocations to suit changes in markets is another matter. If you like the sound of the investment style but need help with the strategy, have a look at the InvestSMART model portfolios. In the long run a mix of low-cost ETFs and professional management is a compelling offer.