Using exchange traded funds to gain access to equities and other securities markets may seem like a simple and cost-effective way to invest, but there are a number of traps to avoid.
Researcher Morningstar has issued guidance for investors using ETFs, spelling out a number of dos and don’ts aimed at avoiding pitfalls that can increase the cost of trading.
Matthew Wilkinson, senior research manager at Morningstar, says: “We use managed investment for diversification, expert securities selection, risk management and for rebalancing.
“If those managed investments are listed we also get ease of access and price transparency. What we don’t like with ETFs and other listed products is that spreads can be unstable if trading conditions are volatile.
“There are some days when the range is far greater than what you would expect. There are spikes, which may result in investors getting bad prices. We like these products but there are things investors need to know.”
The Australian Securities and Investments Commission also has reservations about ETFs. In a review of the local ETF market last year, it said the market was “generally functioning well” and was delivering on promises to investors.
However, it detected some potential risks that require monitoring by issuers and oversight by market operators. It wants them to do more to inform investors about the tracking error of funds, indicative net asset values and trading spreads.
And it is concerned that there too few market markers providing liquidity in the local ETF market.
ASIC says: “ETF trading is generally liquid, bid-offer spreads are narrow and secondary market prices are generally close to the NAV is ETF units. However, this does not necessarily apply to all products at all times.”
“In particular, we observed that spreads do temporarily widen in some circumstances, meaning individual transactions may involve a higher spread than an investor may consider desirable. The spread may significantly affect investor return.”
ASIC has recommended that ETP issuers make indicative net asset values available to investors, which would allow investors to assess the reasonableness of an ETP’s market price. It also wants issuers to provide investors with education about the existence of iNAVs and how to use them.
An iNAV provides a reference point for investors to assist them in understanding if they are purchasing or selling ETPs at or close to NAV.
ASIC says that at the moment issuers do not have a consistent approach to publishing iNAVs. The majority provide iNAVs for Australian equity and fixed income ETPs but not for any international equity or fixed income ETPs.
ASIC wants issuers to disclose both tracking error, which measures the quality of index replication on a day-to-day basis, and tracking difference, which provides a longer-term view of the performance of the ETF against the target index.
Morningstar’s suggests investors follow these rules:
Consider using limit orders, not market orders. A buy limit order will fetch the buyer a price that s equal to or less than the limit price. A sell limit order will transact at a price equal to or greater than the limit price.
Market orders can be useful when time is of the essence and price is of secondary importance, or when there is plenty of liquidity. Investors using market orders want to execute their order as soon as possible.
For large, very liquid ETFs that that contemporaneously with their underlying securities, market orders will likely result in fast execution at a good rice.
But there are smaller or less liquid ETFs, and there are also ETFs that trade out of sync with their underlying securities (such as US equity ETFs) In such cases, limit orders help ensure favourable execution from a price perspective.
Avoid trading at the market open or close, or in the auction period. For ASX-listed ETFs, this means at the very least avoid trading earlier than 10.15 am or later and 3.45 pm. At these times, market makers may not be watching the market as closely and some underlying stocks may not be trading. This makes it more difficult for the market maker to calculate an accurate price.
Check the bid/ask spread. If the spread is wide, it may indicate that something is amiss and it might pay to delay a trade. It is also worth observing the spread to see if it is unstable – that is, narrowing and expanding frequently. If that is the case, it is a sign market makers are adjusting for risk and caution may be required.
Be wary of trading when the underlying securities are not open for trading. ETF trading volumes should be substantially higher and bid/ask spreads will typically be lower when the underlying stocks are also trading and have transparent pricing.
Use trading tools. ETF providers offer tools such as intraday net asset value (iNAV), which can be used to gauge whether an ETF is trading near its NAV. Although there is no guarantee that iNAV will be an exact representation of the NAV, it is a useful indicator.
Check trading volumes and ETF size. An ETF’s size and on-screen trading volume are worth monitoring. As a general rule, the larger the ETF size, the less liklety investors are to have problems trading it.