The Wisdom Of Simplicity In ETF Trading

If you haven’t read Jason Zweig’s most recent piece in the Wall Street Journal called “Trading Without Tears,” read it.

It’s a primer on how to tread carefully when buying and selling stocks in modern financial markets characterized by high-speed electronic trading. An innocent oversight can be hugely consequential, as Zweig points out in his discussion on a single stock, Parsley Energy.

Everything Zweig argues in his latest column applies to exchange-traded funds, though it’s safe to say the pitfalls are probably more numerous when it comes to ETFs. ETFs are in some ways like stocks. But they’re also unlike stocks in that they are baskets of stocks—or many bonds, or bank notes or futures contracts or whatever. This access and price discovery are more complex than with single stocks.

Very Simple Rule

Zweig’s message is very simple: Avoid the use of market orders. It makes me smile when someone as sharp as Zweig says something that’s so simple. Being smart often means thinking with clarity rather than with complexity. This blog is a celebration of simplicity.

To be clear, using market orders subjects you to the vagaries of the markets—high frequency trading and otherwise. Dave Nadig’s recent piece on the surprising prevalence in ETFs of what he called mini “Flash Crashes”—particular at the very end of a trading day was interesting and unsettling. But if you’re avoiding market orders, these moments when markets become unhinged are pretty much irrelevant.

Avoiding market orders leads you instantly to “limit orders,” which enable you to pick your price, and thus steer clear of accidentally executing a trade when the price of an ETF has deviated from its underlying net asset value. A limit order even affords the possibility of doing better than the price you pick.

To borrow Zweig’s example, if you stipulated a “marketable limit order” at $10.05 when the stock was being bid at $10.00 and being offered at $10.02, you’ll actually get executed at $10.02 if the market doesn’t move much, and you’ll never pay more than $10.05 if the market starts moving up.

Beyond Limit Orders

That said, limit orders are in some ways insurance policies for the little guy. They’re totally legitimate, but some bigger advisors, such as ETF strategists who have as clients other financial advisors, go well beyond limit orders to get the trade execution they need.

They carefully set up trades long before any buttons are pushed, keeping at bay the forces in contemporary electronic markets that can cost you dearly.

Ironically, this process of “Trading Upstairs”—of sourcing liquidity and mapping out a big trade involves a network of human beings who are in the trading traffic. Together , all these people—advisors, authorized participants and liquidity providers make sure that what happens in the dark tunnel of electronic trading is exactly what they need and want.

High Stakes

The stakes are high for big-time advisors and small retail investors alike.

To be sure, the arrival of ETFs has been a powerful democratizing force in markets that has pushed down costs of investing and increased access to global markets. But ETFs are not mutual funds that trade once a day after the close at a price that matches net asset value as a matter of course. The fact that ETFs trade all day long is a plus, though that virtue can quickly become a curse.

So, three cheers to Jason Zweig for putting focus on the realities of contemporary markets and on the importance of using tools like limit orders, which, in terms of exchange-traded funds, will help keep the virtues of ETFs virtuous.