The recent volatility in global equity markets should serve as a timely reminder to investors about how to correctly trade exchange traded funds (ETFs). As this note will demonstrate, ETFs have some distinct advantages over other exchange-traded investments, especially during periods of extreme price volatility. That said, even with ETFs there is some risk of poor trade execution when investor emotions are running high – which emphasises the need not to lose sight of a few key trading strategies.
ETFs are better able to track their NAV than LICs
A major advantage of ETFs is that they have dedicated market markers that stand ready to provide bid and offer prices at values close to an ETF’s net-asset value (NAV). The NAV, in turn, is typically the market price of the underlying securities (such as company shares) that the ETF holds, minus expenses. As we have explained in previous posts here and here, competition between these professional traders and the open-ended structure of ETFs helps these “bid-offer spreads” remain relatively tight.
For investors, this means that in most market conditions there is a system in place that seeks to ensure that they are able to buy and sell an ETF at prices reasonably close to its NAV. As we have previously explained, this is quite distinct from the case of listed investment companies, or LICs, which provide no formal mechanism to ensure their bid-offer prices hold close to the NAV of the underlying securities they hold. When there is a flood of selling, therefore, there is a greater risk that the traded price of some LICs fall well below their NAV – providing opportunities for some, but imposing costs on those that have simply wanted to sell as quickly as possible.
For example, as seen in the chart below, the performance of our flagship Australian equities fund, the BetaShares FTSE RAFI Australia 200 ETF (ASX: QOZ), managed to track its NAV quite closely during the recent bout of market volatility.
…but ETFs can’t save you from NAV declines
Despite these benefits, however, it’s worth remembering that the structure of ETFs will not stop their underlying NAV falling – perhaps even steeply – when the market prices of the underlying securities held by the ETF are also in free fall. Indeed, this is the very nature of market risk: ETFs are typically designed to track the movements of a market index. If that market index is falling – because the prices of the underlying securities in that index are falling – then so will the ETF’s NAV. This NAV decline will happen irrespective of whether the degree of decline in the market price of these underlying securities is considered rational or not.
In other words, there is no provision in the market to avoid the price of individual company securities falling well below what many might consider their own “fair-value”. After all, fair-value in this sense is ultimately in the eye of the beholder. As in any market, panic selling may sometimes throw up bargains – and ETFs are no exception.
Two Traps to Avoid
Given the potential for sharp drops in an ETF’s NAV in line with the price of underlying company securities in general, then like most exchange traded investments ETF trading can still present traps for the unwary investor. To avoid these traps, two key trading strategies need to be kept in mind.
For starters, investors need to be very wary of placing “market” orders – a “market order” occurs when an investor agrees to sell (or buy) their ETF units at whatever price the market is currently willing to pay. If there are many market orders at the same time – relative to the level of demand at the best currently available bid price – there is the risk of the order being filled by other less attractive bids that are also in the market but at much lower levels below the ETFs current NAV. Such “bad fills” are sometimes evident by large spike-downs in price on intra-day price charts.
To address this risk, investors are better advised placing limit orders – whereby they agree to sell but only at a certain minimum price (such as at, or just below, the best current bid price in the market). While this may mean some trades are not filled immediately, it does reduce the risk of “bad fills.” What’s more, due to the presence of active market makers, investors should not have to wait too long to have their order filled at prices that are still quite close to the current NAV (provided the NAV has not moved too far in the meantime). That’s because if a large sell order momentarily depletes the bid volumes at current market prices, market makers should quickly replenish this volume at similar prices provided the ETF’s NAV has not moved too far.
Similarly, investors should actively monitor any in-place stop loss trades during a volatile market – as there is a risk that these sell orders could be hit should prices gap down due to a “bad fill” for another panicked investor as described above, rather than due to an actual decline in the ETF’s fair-value.
In this regard, it’s worth remembering that this caution is no different to that which applies to trading company securities in general. In times of market panic – when prices are at risk of gapping down due to a flood of sell orders – all investors with stop loss orders in place (even at prices well below current market prices) are at risk of having shares sold at momentarily low prices.