How To Minimize Your Cost Of Trading ETFs

June 22, 2009

IllustrationOne of the features that long-term investors like most about exchange-traded funds is that each shareholder usually pays only the cost of his or her own fund share transactions and is protected by the ETF structure from the cost of other investors’ purchases and sales of fund shares. In spite of this feature, there is a great deal of misinformation in circulation about the cost of trading ETFs and how to trade them efficiently. This article tries to help you evaluate the quality of ETF markets and keep your ETF share trading costs low.


Trading ETFs Is Different Than Trading Stocks

A natural reaction to the title of this article is, “Why bother to write about trading ETFs? They trade “just like a stock.”

In fact, the reason for writing this article is that ETFs don’t trade like stocks. ETF markets behave differently than stock markets, and ETF shares trade differently than stocks in a number of ways.

Figure 1 lists some of the similarities and differences. To illustrate one difference, ETF investors have learned that ETF bids and offers usually change much more frequently than stock bids and offers. These more frequent changes can make ETF investors uneasy, as they suggest that individuals do not have as much information as professional traders have about what the ETF price should be or what the ETF bid or offer will do next.

Even if your only interest is in day-trading one of the several dozen major benchmark index ETFs that trade more than 10 million shares on an average day, the market in ETFs is different than the market in common stocks in ways that can affect your trading results. If you trade ETFs that are not based on major benchmark indexes or that trade fewer than 10 million shares a day, ignoring the significant differences between ETF and stock trading can be very costly.

This article will help investors find level stretches of the ETF playing field where professional and amateur traders have equal footing—and avoid the slippery slopes. Once you understand how the ETF market works, and how trading ETFs differs from trading stocks, you will be able to trade ETF shares confidently and efficiently. In fact, with the introduction of net-asset-value-based trading in ETFs, trading ETFs can be much simpler and less stressful than trading stocks.1

While the focus of these comments is on U.S.-listed ETFs holding U.S. common stocks, many of the observations apply to European and Asian ETF markets and to U.S. ETFs with other portfolio holdings.

The entry in Figure 1 that generates the most questions from investors is the trading hours for ETFs. Trading after 4:00 p.m. presents both opportunities and hazards to ETF traders. Trading in ETFs is active until well after 4:00 p.m., partly because the major benchmark index ETFs (such as the S&P 500 SPDRs, the iShares Russell 2000 Index Fund and ETFs tracking a number of other popular benchmark indexes) are part of major arbitrage complexes. These arbitrage complexes typically consist of an index that serves as a template for index mutual funds and other indexed portfolios and for a variety of index derivative financial instruments, including index futures contracts, index options and, of course, index ETFs. The arbitrage complexes also include derivatives on these derivatives, such as options on futures, options on ETFs and securities futures products (single “stock” futures) on ETFs. There are also exchange-traded and over-the-counter structured products and risk management contracts linked to many of these indexes.

Figure 1

 

Until the NYSE acquired the Amex in 2008, ETFs—like most of the other tradable components of the index arbitrage complexes—traded in a regular session that lasted until 4:15 p.m. to provide a structured ETF market that was fully contemporaneous with the futures markets. Since the change to a formal close at 4:00 p.m., ETF volume between 4:00 p.m. and 4:15 p.m. has not changed materially. On May 15, 2009, the day before this article was prepared for submission, ETFs were four of the five most active issues in after-hours trading. One of that day’s most active after-hours ETFs is based on an index that does not have an active futures contract.

 

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