Exchange-traded funds, or ETFs, have become an increasingly popular investment choice. But many investors are more familiar with mutual funds, which hold the lion’s share of retail investment assets.
Both funds are baskets of securities that are selected and maintained based on a particular management formula or strategy. And while both mutual funds and ETFs can offer investors a low-cost investment strategy, there are some notable differences between these two investment vehicles, especially when it comes to trading.
If you’re using ETFs in your portfolio, it’s important to understand and take advantage of those trading differences:
- Pricing and trading units: A mutual fund trade is calculated in U.S. dollars. In other words, you buy a set dollar amount and that gets you the proportionate number of shares, including fractions of shares. With an ETF, you place an order for a specific number of shares and the total price that you pay is the share price times the number of shares. Simply put, you cannot place an ETF order for a dollar amount and you cannot place a mutual fund order for a number of shares.
- Buying and selling: Mutual funds are bought and sold only at the end of the trading day, after all securities have been repriced. An investor selling a share of the mutual fund would receive the exact same amount as anyone else selling shares of the same mutual fund. ETFs are bought and sold through major exchanges at any time during a trading day. An ETF trades like a stock in that there is a bid price (the price an investor is offering to pay for a share) and an ask price (the share price an investor is offering to sell a share). The difference between the bid and the ask price is called the “spread,” and that can vary depending upon trading activity.
- Minimum investment: With most mutual funds there is a minimum dollar amount that you must buy, which might be as high as $1,000. The minimum investment with an ETF is whatever the price of one share might be at that time, perhaps as low as $10.
- Automatic reinvesting: With many mutual funds you can have the dividends and capital gains automatically reinvested in additional shares. ETFs do not offer this feature.
- Tax efficiency: Since mutual funds are bought and sold at the end of the day, this can require the fund manager to liquidate securities in order to match demand. ETFs are not held to the same standard and therefore, in a taxable account, you may pay less in the way of income tax on capital gains at the end of the year.
- Settlement time: Most mutual funds settle in one day. This means if you sell your mutual fund on one trading day you will have your cash on the next trading day. ETFs settle in three days in most cases.
5 trading tips
So how do you use these differences to your advantage? Here are five tips that will help you make the most of your ETF trades.
- Think twice about when you buy and sell. Avoid trading in the early morning and at the end of the day. These are the times when markets are most active, which can lead to some mispricing of securities in the ETF. In other words, you could be paying more than what the basket of investments is worth.
- Avoid volatility when possible. Avoid trading on days with higher than normal market volatility, which can result in wider bid-ask spreads. Though volatility is generally unpredictable, there are a number of events that can trigger higher volatility. For example, the stock market might experience increased volatility when a Federal Reserve Bank policy decision is announced or when key economic data is released.
- Place limit orders when you make a trade. When an investor places an order to purchase or sell a stock or ETF, he or she has two execution options. Most common is a market order, which is an instruction to execute the transaction as quickly as possible at the present price, or market price. A limit order is an instruction to execute the trade at or under a particular purchase price or, if you are selling, at or above a designated sale price. For investors buying or selling ETFs, limit orders have some advantages over market orders since they offer some price control and thus protection. The limit also tends to establish a boundary around your preset transaction price. However, be aware that a limit order may not necessarily get filled.
- Pay close attention to timing with international ETFs. Trading an international ETF can be a little tricky. It’s important to trade foreign ETFs during a window of time that best correlates to the trading hours of the underlying securities’ market. For example, if the underlying securities were traded on the London stock exchange, you’d want to trade when the FTSE — an index that tracks companies listed on that exchange — is open. Typically, the price of an international ETF tends to be closer to the underlying securities’ value during the times when the trading hours of their market and the U.S. market overlap.
- Don’t fly solo with a large trade. All investors use a custodian or broker to access the market, but they can either place the order online or have the staff of the broker place the trade on their behalf. If you trade ETFs in a larger share amount — say, in excess of 10,000 shares — the “block desk” of your brokerage firm could provide invaluable help. They often have the ability to obtain the best securities, trading strategies and liquidity options otherwise unavailable to the typical investor. Be aware that there is a fee for the service, but it won’t be much, and for big orders it’s worth it.
ETFs can offer investors a great way to implement a low-cost investing strategy, but it’s important to focus on keeping trading costs under control. This is especially true when trading larger amounts, where investors can unwittingly run up their costs. If you have any issues, problems or questions, you can reach out to your ETF provider or your broker for help.
And for the best ETF trading experience, make sure to understand how these investments differ from mutual funds and individual securities. It may make you even more successful in executing your trades.
Michael Chamberlain CFP® is the owner of Chamberlain Financial Planning and Wealth Management, a fee-only firm with offices in Santa Cruz, Sacramento and Campbell, California.
This article also appears on Nasdaq.