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Monday, July 20, 2009

Tips for trading ETFs

The more an ETF is traded, the more liquid it becomes, making it even more attractive relative to its less-liquid competitors. Based on conversations with people at various ETF providers, the firm learned that it takes roughly $100 million in assets for a company to justify the expense of offering an ETF. Investors should avoid the risk of investing capital in a product that might be liquidated in the future by evaluating the level of assets in a strategy before committing money to an ETF.

Another indicator of an ETF's liquidity is the bid-ask spread. The bid-ask spread is the difference between the highest price a buyer is willing to pay for an asset and the lowest price at which a seller is willing to sell that same asset. As liquidity increases for a particular product, the spread will narrow, thereby limiting trading costs. Low spreads are good because they reflect a more efficient market for an asset.

However, spreads vary by asset class, among others things. For example, ETFs that track the S&P 500 should have very low spreads because the underlying securities in the S&P 500 are very liquid and easy to access. Some foreign securities, particularly those in emerging markets, may be less liquid and require a wider spread. ETFs that track bonds, particularly less-liquid, high-yield bonds, may trade at wider spreads simply because bonds do not trade on an exchange and therefore are not priced as efficiently as stocks.

Investors should aim to limit trading costs by avoiding illiquid ETFs with wide bid-ask spreads. There is no absolute level of spread we can point to as a threshold for investing in a product or not. However, investors should compare the bid-ask spread of the product they are interested in to other similar products.

Investors also should evaluate whether or not an ETF has been trading at a significant premium or discount to NAV. More ETFs than ever have traded periodically at substantial premiums and discounts in the past few quarters as the capital markets have been stressed. Fixed-income ETFs especially have seen some large premiums and discounts.

There are a few guidelines investors should be aware of regarding the timing of trades. The first general rule is to not trade ETFs at the very beginning or end of the trading day. Spreads tend to be wider at these times than at other times during the trading day, because there isn't as much information priced in during these times and because some of the underlying securities in the portfolio might not be trading.

The second general rule is to try to trade an ETF when the markets for the underlying stocks are open. This pertains mainly to international ETFs. For example, if an ETF has European stock exposure, the spreads on the ETF may be wider after European markets have closed, but while the U.S. market is still trading.

Disclosure I am long many ETFS and they are a important part of my portfolio., Inc.

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