Some investors gloss over the "ET" in ETF, failing to understand or appreciate what these two letters stand for and the implications of investing in a fund that trades like a stock. The exchange-traded nature of these funds is increasingly taken for granted as many of the largest ETFs trade at tight spreads in very narrow bands around their net asset values through most market conditions. But not all ETFs are created equal from a liquidity perspective, and investors shouldn't take ETFs' liquidity for granted. Also, the market mechanisms that underpin the ETF ecosystem have experienced hiccups of varying magnitude, ranging from the "flash crash" to more recent episodes of lesser scope and impact. These events have served as painful reminders of why investors should exercise caution when buying and selling ETF shares. Here I provide five tips on how to best trade ETFs.
1) Use limit orders.
If I had to provide just one tip, this would be it. Use limit orders when trading ETFs. Investors tend to use market orders in instances where time is of the essence and price is of secondary importance. Investors using market orders want to execute their entire order as soon as possible. For very large, very liquid ETFs that trade contemporaneously with their underlying securities, like SPDR S&P 500 (SPY), market orders will likely result in fast execution at a good price. But most of the 1,700-plus exchange-traded products on the market are smaller and less liquid than SPY and its ilk and may also trade out of sync with their constituent securities.
Ben Johnson, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.