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ETF Trading Best Practices

Scott Burns

Scott Burns: ETF trading best practices. Hi there. I'm Scott Burns, director of ETF research with Morningstar. Joining me today is our director of North American ETF research, Paul Justice. Paul, thanks for joining me.

Paul Justice: Always a pleasure.

Burns: In light of the flash crash a couple of weeks ago, I think that we were all served a very important reminder that ETFs, although they are like mutual funds, do trade on exchanges. And there's that capital markets aspect of investing in ETFs that can really trip up investors.

I asked you to join me today to talk about what are the best practices investors can use when buying ETFs to make sure they are getting the best capital markets execution.

Justice: You're right. An ETF can perform a lot like a mutual fund. But "like" and "the same" are two different things. You have to worry about execution when you're talking about ETFs, especially in the pivotal moments when you're deciding to get in and out. That's when you have to worry about the order execution.

So we start thinking about making sure you're getting a fair shake with your ETF trade, and that involves taking actions such as placing a limit order, specifying a price in which you're willing to buy or sell that ETF.

And we often look at a reference point for an ETF to make sure you're getting a good value there. It's the Indicative Value Index, which you can look up on Morningstar or Yahoo or any other system that you want to, to find out what the basket of underlying stocks is worth.

So make sure you get very close to what that indicative value is. That's one practice you can use, as opposed to taking a market order.

Burns: So just to walk back over that, you're at your terminal there or your computer, and you're getting ready to place the trade. You want to make sure you hit a limit order, and a limit order means, basically, "I'm only going to buy at this price."

Justice: Right. And when you do this you have to understand that if it doesn't hit that price, you might not get execution, but at least you've set a boundary at where you're looking at getting that fair price, if that's what you're worried about.

If the execution is paramount, perhaps set your limit order just a little bit lower to ensure that you're going to get the order executed, and not have the market run away from you. I would say the events of May 6th were extraordinary. They're not going to happen all the time, but you can't predict when they will.

Burns: Right, right.

Justice: So just take a little bit of extra care to ensure you're not the victim of a wide price swing.

Burns: Right. In general, do we find that that indicative value sits between the bid-ask spread that's often quoted?

Justice: Most of the time. ETFs are very efficient when the markets are functioning properly. There is an incentive out in the marketplace for market makers and authorized participants to ensure that the indicative value is close to what the price of the ETF is.

So over 99 percent of the time, you're going to get something close, but just be careful. Make sure that you're one of the 99 percent.

Burns: Right. So what about trading less liquid ETFs? I think that's really come back to the fore. I've been kind of surprised that in October of 2008, where we had a tremendous amount of volatility, even less liquid ETFs performed very well. But here in the flash crash, we had a lot of problems.

Justice: Sure. One, we saw an absence of buyers, and there were disruptions in the marketplace. Since you're not dealing with end-of-day net asset value like you are with a mutual fund, that's when order execution becomes paramount.

One recommendation is, avoiding trading during extremely volatile periods. There's no reason why you had to sell. But if you had this inclination to sell at that given point, a limit order could have saved you either from not getting execution or at least getting a fair price. So I think that's something investors really need to consider.

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Burns: Any other tips that investors should really look out for when they are dealing with the capital markets nature of ETFs?

Justice: Yes, well, I think that ETFs are kind of the hybrid of the mutual fund and the stock. Some practices that work well for stocks don't work well for ETFs. If I have a core holding in my portfolio, something that makes up 30-40 percent, or anything over 10 percent...

Burns: Something like a broad market index, total stock market.

Justice: Something that fits in an asset allocation context, those are something that I don't want to put a stop-loss order on. A stop-loss is effective for somebody who is trading stocks very frequently, and they're not going to be upset if they have to part with that holding.

When you're doing asset allocation, you're already setting a risk tolerance. You've decided between your mix of bonds and stocks how much risk you're willing to take. If you're using a stop-loss order on something that's supposed to be very long-term, you're giving yourself a false sense of security.

It's not providing you insurance. In fact, in those disastrous moments, it's basically guaranteeing that you're going to lose money. So use order methods for which they were intended. A stop-loss, not appropriate for an asset allocation purpose.

Burns: Right. Is there a stop-loss limit version?

Justice: There is a stop limit, but you don't get guaranteed execution on that. On that Thursday, it really wouldn't have helped you at all, because chances are if you hit a limit -- say, 10 percent below the market price -- the stock market blew right through that and sat below it.

So you wouldn't have gotten an execution on the way down, but when the market recovered, which it did very quickly -- within 20 minutes -- the market trends upwards, and that's when the bids and asks become more compact and orders are executing more efficiently.

That standing order would have then been executed on the way up, so you still would have lost 10 percent on that holding. Then the market ends up closing down three percent. So it wouldn't have saved you anything.

Burns: Well, that's definitely good advice, Paul, and I think investors really need to make sure. ETFs are a great tool, but they do have that capital markets aspect, and it's something that in order to avoid an adverse investing experience, an investor really needs to make sure they're educated on before they dip their toes in there.

Justice: I agree. ETFs are great. You can save yourself some fees and get some tax efficiency, but you have to deal with the little bit of added complexity and make sure you execute the orders properly.

Burns: All right. Well, thanks for joining me. I'm Scott Burns, director of ETF research with Morningstar. For this and other ETF commentary, please check out the ETF Center on Morningstar.com, and Morningstar's ETF Investor Newsletter.