The Ways to Minimize the Risk in the ETF Trade

Here are some tips for trading ETFs in a wildly gyrating market.

Choose Carefully

Investors trying to gauge which ETFs are cheapest and easiest to trade need to keep two factors in mind: how frequently the stocks or bonds that make up the ETF trade, and how frequently the ETF itself trades.The efficiency of an ETF depends on the efficiency of the underlying stocks. A fund that owns a giant auto maker will typically trade more smoothly than one made up of its tiny, thinly traded parts supplies. But it’s also important to weigh the trading volume of individual ETFs, since heavy volume benefits small investors.

Keep a Close Watch

There’s a wealth of information available to make sure an ETF is on track before you trade.

First, check whether an ETF’s market price is close to the value of its holdings, known as its net asset value, or NAV. ETFs have a special mechanism that creates and redeems fund shares in line with investor demand. The mechanism is supposed to all but eliminate premiums and discounts relative to NAV, and it works well — but it’s not perfect.

Investors can see an ETF’s premium-and-discount track record on the Web site of the fund company that offers it. The SEC requires firms to publish graphics showing the number of days each ETF closed at a significant distance from its NAV. But these graphs give only a broad historical picture, and they’re usually updated only once a quarter, so recent problems may not have shown up yet.

To make sure an ETF is trading accurately when investors actually want to buy, they need to find its indicative intraday value, or IIV, an estimate of NAV that ETFs publish every 15 seconds throughout the day. There’s a separate ticker symbol for the portfolio’s IIV which investors can punch in and compare to the fund’s trading.

The other number investors need to check is the bid-ask spread. At a penny, the spread on SPDR is just 0.01% of the recent price of a SPDR share. But recently, fear and uncertainty have driven spreads on dozens of ETFs above 0.5%. And a handful have reached above 5%. While investors should see an ETF’s current trading spread on their brokerage firm’s Web site before placing an online order, getting historical spreads can be difficult. Unlike premiums and discounts, spread information isn’t usually available on fund-company Web sites.

Tricks of the Trade

There is no guarantee every trade will receive flawless treatment. Trading problems can affect even the most experienced investors.

One frequently cited solution is to use “limit” rather than “market” orders. Limit orders instruct brokers to buy shares only if they can find them at or below a given price, not at whatever price the market offers.

Investors making large purchases also might consider breaking their orders up into small chunks to ensure all the shares receive quoted prices. Bid-ask quotes usually apply only to a few hundred shares, so with large orders, significant swaths can get filled at less-attractive prices.

Time of day can also matter. Bid-ask spreads tend to be significantly wider in the minutes after the markets open than they are midday. That’s because market makers are unsure how to value ETFs before the funds’ underlying holdings have started recording prices.

Still, nothing works all the time. If prices are moving fast, strategies like limit orders or waiting for a calmer market also can lead to missed opportunities.