An investor’s guide to ETFs

It appears that ETFs are here to stay with a total market share of nearly $9 trillion in the U.S. alone.¹ For seasoned investors or those just starting out, though, it never hurts to brush up on the best practices when trading ETFs. Using the right kind of broker order and knowing when it might make sense to avoid trading ETFs can help investors get the best pricing and execution on their transactions.

Here are answers to some of the most common investor questions about trading ETFs:

What are the potential costs associated with trading ETFs?

Most investors are probably familiar with ETF expense ratios, or the annual fees that shareholders pay the issuer. When trading ETFs, there are other potential costs to be aware of, including:

• Bid/ask spreads: The bid/ask spread is the amount by which an ETF’s ask price exceeds the bid price in the market. Narrower bid/ask spreads generally mean lower trading costs for investors, while wider bid/ask spreads can increase the cost of executing ETF transactions.
• Premiums and discounts: The price of an ETF, or stocks and other investment vehicles, can trade at a premium or discount to its net asset value (NAV) due to supply and demand forces in the marketplace. If an investor buys an ETF trading at a premium to NAV, it generally means higher transaction costs. On the other hand, selling an ETF trading at a discount to NAV can also cost investors, all else equal. Investors can monitor ETF premiums and discounts to potentially avoid overpaying for an ETF, or selling for less than the NAV.
• Brokerage commissions: Although many brokers today offer commission-free trading for ETFs, investors should always confirm if they are required to pay for their ETF trades. 

What’s the difference between a market order and a limit order when trading ETFs?

When trading ETFs at a brokerage, two of the most common order types are market orders and limit orders.

• Market orders: A market order is an order to buy or sell an ETF, or other security, immediately at the best available quoted price. Market orders help ensure the trade is executed quickly. The other side of the coin is that transaction costs may increase, particularly in volatile markets.
• Limit orders: With a limit order, the investor can specify a target price when buying or selling an ETF, stock, or other security. Limit orders give investors more control over the execution price, although there is no guarantee the trade will happen if the ETF’s share price does not come down to the limit order price.

Are there particular times of day to consider avoiding ETF trades?

One generally accepted rule of thumb when trading ETFs is to avoid buying and selling near the market’s opening and closing times. In particular, the first and last 30 minutes of a trading session can be more volatile, which may lead to wider bid/ask spreads.

How can I evaluate the liquidity of a particular ETF?

If an investment is considered liquid, it means investors can buy and sell it without significantly impacting the price. When researching the liquidity of an ETF for efficient trading and minimal transaction costs, here are some factors to consider:

• Bid/ask spreads: As discussed earlier, bid/ask spreads can impact transaction costs and narrow spreads generally indicate better liquidity. Investors can monitor ETF bid/ask spreads and other ETF data in real time through their brokerage firms or financial news websites.
• Average daily trading volume: Although trading volume doesn’t tell the whole story of an ETF’s overall liquidity, many investors start there. It’s also important to keep in mind that the liquidity of the asset class the ETF invests in also influences its liquidity.
• Size: Although the liquidity of an ETF depends on many factors, larger ETFs with significant assets under management tend to be more liquid.
• Underlying Holdings: Each ETF’s underlying holdings can be a driver in a fund’s liquidity. ETFs are generally at least as liquid as their underlying holdings.

When it comes to trading ETFs, a little knowledge can go a long way. Understanding the factors that impact ETF prices can help investors improve the costs and execution of their purchases and sales.