Five Best Practices for Trading ETFs

With so many different trading metrics and order types available, it can be difficult to effectively navigate the significance of each, especially during times of heightened volatility. When it comes to exchange-traded funds, or ETFs, seemingly small trading factors can have a big impact on the overall investment. Here are a few tips to help you navigate the ETF space.

Mind Your Order Type Usage

Order-type usage is one of the most basic and easily implemented methods to consider. Many investors automatically use market orders when placing trades, which means their orders will be filled as soon as possible at the best price available at the time. With market orders, the priority is execution, not price. This approach is useful if an investor needs to enter or exit a position immediately. However, if an instantaneous trade is not necessary, consider using a limit order instead.

Never heard of a limit order? A limit order is designed to prevent orders from being filled at an unwanted price. Essentially, an investor sets the price at which they want to buy or sell the security and the number of shares they would like to buy or sell. That order will only execute at the investor’s specified price or better. However, because of the specified price, the order may not be filled immediately or completely with a limit order.

The chart below shows the most popular order types used to trade ETFs on Cboe's™ exchanges in July 2020:

Although market orders account for only 1% of ETF shares traded on Cboe, they are still widely used when trading off exchange through broker/dealer platforms. Market orders have the potential risk of sweeping through the order book’s liquidity while executing at various prices, which can result in higher transaction costs. Take the example below:

Let’s say an investor submits a market order to buy 3,000 shares of an ETF, but there are only 1,000 shares available at the national best offer. The first 1,000 shares of the order were filled at the national best offer; however, the remaining 2,000 shares were filled at the next-best price away from the previous national best offer, costing the investor an extra $325 to access the additional 2,000 shares.

If the investor had used a limit order instead, the 3,000-share order would have been partially filled with 1,000 shares at $25.05 and the remaining 2,000 shares would have been queued for an execution at $25.05 as the market reacts to the sell liquidity at $25.05 being taken off the book.

Incorporating limit orders into an everyday strategy may help lower the overall trading cost by providing investors with control over the maximum or minimum price at which they’re willing to buy or sell an ETF.

Consider the Time of Day

The time of day ETFs are traded can make a big difference. ETFs generally have wider spreads throughout the first and last 15 to 20 minutes of trading in comparison to the rest of the trading day. 

In the chart below, you can see the bid-ask spread (green line) clearly increase around the open (black boxes). The larger the bid-ask spread, the more expensive it is to enter and exit the position, causing the investor to leave more money on the table.

The above spread data is for the Wedbush ETFMG Video Game Tech ETF (Ticker: GAMR). On July 14th, 2020, GAMR’s spread increased the most within the first five minutes of trading when compared to the rest of the trading day. Although there was a minor spike in the bid-ask spread towards the close, GAMR closed with a spread of $0.11 which is much tighter than the $0.55 spread around the open. A wide bid-ask spread around the open is not uncommon for many ETFs and equities, especially in times of volatility.

To help combat wider spreads around the open and close, Cboe has implemented specific auction participation requirements for Lead Market Makers (LMMs) to meet in order to receive incentives. Learn more about Cboe’s auctions here.

Take ETF Market Quality into Account

Many investors look at the expense ratio of a fund when deciding whether to trade a certain ETF. Expense ratio is important, but the spread and liquidity in the product can be just as crucial.

For example, the total cost of ownership for an ETF with an average spread of $0.15 and an expense ratio of 0.50% may actually be more expensive to own than an identical product with an average spread of $0.07 and an expense ratio of .55%, depending on how long each ETF is held. The cost of trading in and out of a position is a factor many do not often consider, but the difference between the bid-ask spread is a real cost that investors experience every day when trading any sort of equity.

Additionally, depending on how many shares an investor is trying to trade at once, it is wise to consider the average size at the National Best Bid and Offer. This is important so when the future order is placed to exit the position, the investor has an idea of how many shares will be filled at the national best bid and how many will be queued, canceled or executed at a greater cost. As a result, the product with the slightly higher management fee may be less expensive to own compared to the identical product with the lower management fee. 

Do Not Solely Rely on iNAV

The intraday net asset value, better known as iNAV, is the estimated real-time value of all the underlying assets the ETF holds. Many investors use this data point to determine if an ETF is trading at a premium or discount to its underlying holdings and make trades accordingly. Although this seems like a great factor to look at when trading, it may not paint the full picture in certain securities.

When trading U.S. equity-based ETFs, iNAV can be a great tool for investors to see the real-time underlying value of the ETF’s holdings. This is due to the underlying holdings typically having the same trading hours as the ETF and not incorporating any securities other than U.S. equities. However, iNAV is not a “one-size fits all” when looking at the real-time value of ETFs underlying holdings for all asset classes.

Various complications with iNAV may lead to investor confusion. iNAV is generally published every 15 seconds, which could cause some price dislocation between the time that the iNAV was last updated and the time that an investor places an order. Additionally, for ETFs containing non-U.S. equities in their underlying holdings, when the underlying market is closed and the underlying securities are not trading, the iNAV becomes a stale, ineffective representation of the true value of the underlying assets.

In the above example of JPMorgan’s BetaBuilders Europe ETF (Ticker: BBEU), from July 23rd, 2020, you can see the green line (iNAV) begin to flatten out around 12:00 p.m. EST, which is shortly after the time most European markets close, meaning the underlying securities of the fund ceased trading for the day. An investor trading based on the iNAV at 3:00 p.m. EST may mistakenly think they just found a big win due to the iNAV showing the ETF trading at a massive discount to its underlying holdings, when in reality the iNAV is flat due to the underlying securities’ primary markets being closed.

ETF.com recently reported that iNAV data is inaccurate for 80% of all ETFs. Additionally, iNAV is no longer required for funds that comply with the SEC’s new ETF Rule, Rule 6c-11. Cboe also filed to remove the iNAV requirement from its generic listing standards and became the first exchange to receive approval to do so.

Capital Markets Desks May Help with Large & Complex Orders

When trading a large and/or complex order, it may be helpful to reach out to the issuer’s capital markets team before entering the order. Many ETF providers have dedicated capital markets teams who will help facilitate trade execution with a liquidity provider. This process will generally ensure the order is executed at a fair price by preventing the entry of an order that would have otherwise burned through the book and/or blown out the spread. For instance, if an investor wants to trade 2,000 shares of an ETF but only sees 300 shares at the national bid or offer, the ETF provider’s capital markets team may be able to help by facilitating the trade directly with a liquidity provider. A scenario like this is common in new launches and/or thinly traded securities.

The contact information of capital markets teams can usually be found on the issuer’s website. A simple step like this may save an investor from trading costs associated with large and/or complex orders.

In Conclusion

The above best practices are just a few of the many practices to be mindful of when trading ETFs. When trading ETFs, keep in mind:

• Order type usage can greatly impact trading costs
• Costs associated with trading in and out of positions can vary by time of day
• Consider ETF market quality in addition to expense ratio
• iNAV may not always be an accurate representation of the underlying holdings’ value
• Reach out to the issuer’s capital markets team for help executing a large or complex order

Learn more about Cboe’s ETF offerings here.

The information in this blog post is provided for general education and information purposes only. No statements within this blog post should be construed as a recommendation to buy or sell a security [or futures contract, as applicable] or to provide investment advice. Supporting documentation for any claims, comparisons, statistics or other technical data in this blog post is available by contacting Cboe Global Markets at www.cboe.com/Contact. Past Performance is not indicative of future results. Cboe, is a registered trademark of Cboe Exchange, Inc.  

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