NOVEMBER 30, 2008, 9:12 P.M. ET Exchange-Traded Funds
The Tricks of the ETF Trade
In these volatile markets, there are ways to minimize unforeseen costsBy IAN SALISBURYArticle
Comments
more in Markets Main »Trading exchange-traded funds in a rocky market can be tricky, but there are things investors can do to minimize the risk.
Investors have come to love ETFs -- which resemble ordinary mutual funds but trade throughout the day like stocks -- as simple and efficient ways to buy and sell baskets of stocks or other securities.
The Journal Report
See the complete Investing in Funds: A Monthly Analysis report.The recent market turmoil, with the stock market moving hundreds of points a day, has highlighted ETFs' trading advantages: An investor who decides to buy or sell at, say, 11 a.m., can do so immediately, while orders for ordinary mutual funds will be executed at prices that are fixed only after the end of the trading day.
Investors poured $73 billion in additional dollars into stock ETFs during the third quarter, even as they yanked $77 billion from conventional stock funds.
But ETFs aren't perfect, and the credit crisis also has highlighted a number of shortcomings -- from extra trading costs to unpredictable prices.
Some ETF traders have been tripped up by unusually wide bid-ask spreads -- small premiums investors pay to market makers every time they buy and sell. Other investors have faced outsize premiums and discounts, as ETF prices moved significantly higher or lower than the putative value of the underlying assets.
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," says James Ross, senior managing director at State Street Global Advisors, a unit of State Street Corp. and a major ETF sponsor. A fund that owns a giant auto maker will typically trade more smoothly than one made up of its tiny, thinly traded parts suppliers, he adds.
That's why the SPDR Trust, which follows the Standard & Poor's 500-stock index, and the Dow Diamonds Trust, which tracks the Dow Jones Industrial Average, usually get sterling marks from traders, while more exotic funds that target small companies or assets like preferred shares draw most of the complaints.
But it's also important to weigh the trading volume of individual ETFs, since heavy volume benefits small investors. Consider State Street's SPDR and the iShares S&P 500 Index Fund, which both own essentially the same stocks. With SPDR, which trades about 435 million shares a day, investors pay a spread of about a penny a share. With the iShares fund, which trades about eight million shares a day, trading costs are closer to two cents.
A spokeswoman for Barclays PLC's iShares group says iShares S&P 500 Index Fund trades efficiently compared with the vast majority of other ETFs.
Similarly, one might not expect iShares Russell 2000 Index Fund to be among the most liquid of ETFs, because it focuses on small, thinly traded companies. But it happens to be a favorite of many hedge funds that trade it in large blocks -- about 130 million shares change hands each day -- so it's far cheaper to buy and sell than investors might expect. Typically its spread is about a penny a share.
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.
Amid the bond-market turmoil in October, iShares Lehman Aggregate Bond Fund, a broad, supposedly liquid ETF that tracks the whole bond market, closed 8.9% below the value of its holdings one day. Dozens of other bond funds also had problems.
Barclays says the discrepancies were caused by stale prices used to calculate bond indexes, and were not a problem with the funds themselves. Still, the incident highlights how important it is for investors to check before they buy or sell.
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 -- also available on fund-company Web sites -- which investors can punch in and compare to the fund's trading price.
Christophe VorletThe two prices should generally be within a few pennies for stock funds.
A prominent exception is foreign-stock ETFs: The IIVs can't be updated during hours when the home markets are closed. In those periods, news or U.S. market action may lead the ETFs to trade significantly above or below their most recent NAVs.
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, including at least one of the much-anticipated new actively managed ETFs, have reached above 5%.
Invesco Ltd.'s PowerShares unit, which runs the active ETF, says it uses "the largest and most sophisticated market makers in the industry" to keep its ETFs trading as efficiently as possible, but "spreads may widen on all ETFs in abnormally volatile markets."
While most ETFs still have tight spreads, J.D. Steinhilber, an investment adviser in Nashville, Tenn., who specializes in ETFs, says he always checks before he buys. Mr. Steinhilber has been dismayed at some of what he has found recently.
"I try not to buy anything that has a spread wider than a nickel," he says as a rule of thumb, since it's quicker to glance at the raw numbers than figure the percentages. "That's a significant cost. You've got to factor that in" to the overall cost of owning the shares.
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. During one of the most tumultuous days in September, a market glitch led some ETFs to briefly trade at prices that were double or more their underlying values. Exchanges ended up canceling thousands of poorly executed ETF and stock trades. But some investors were still unhappy.
Trading problems can affect even the most experienced investors. PowerShares Chief Executive Bruce Bond says his own broker had to contact one of the exchanges earlier this year after an order to buy an ETF for Mr. Bond's personal account was filled at an inexplicably high price.
"They broke the trade," he says. "But that's why it's important to watch."
One frequently cited solution -- beyond checking your trade execution after the fact -- 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 -- say, more than 25% of an ETF's average daily trading volume -- 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. (You don't have to be wealthy to get over that 25% threshold in some smaller ETFs, which may trade just a few hundred shares a day.)
Some professional traders spend hours nibbling at blocks of ETF shares offered at just the right price.
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.
"You generally don't want to do anything on the open," says Mr. Steinhilber. "It's buyer beware." Recent events have proved the final hour of trading can also be tumultuous.
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 -- proving penny-wise and pound-foolish.
—Mr. Salisbury is a reporter for Dow Jones Newswires in Jersey City, N.J.
Write to Ian Salisbury at ian.salisbury@dowjones.com
online.wsj.com |
