Four ETF Rules to Live By

In general ETFs are excellent investment vehicles. They are liquid and transparent, for one thing — you can always see what they hold, unlike the mutual funds. They also trade in real time, like stocks, and typically have lower management fees. ETF are just better technology than mutual funds. It is no wonder that ETFs are rapidly replacing mutual funds as investment vehicle of choice.

But, in meeting with a number of investment advisors and managers recently, it has became abundantly clear to me that trading ETFs requires additional knowledge and experience. I am not talking about trading larger names such as SPDR Dow Jones Industrial Average ETF Trust (DIA) or PowerShares QQQ (QQQ), for example, but I am talking about most of other exchange traded funds. If you trade such names, the spread between their bid and ask prices tends to be a penny — which is great, of course. That signals liquidity, and it means there’d be no issues buying or selling, or even selling short.

Barring the large funds, then, here are my four practical rules for trading ETFs.

1. Never trade at very beginning or at the very end of a trading day. Trading right at the first half-hour or last half-hour of the session is not a good idea in general, and this is especially true for ETFs. When the market opens up, traders, speculators, market makers, authorized participants (APs) — i.e., ETF market-makers — need to settle in and unwind their overnight positions or capture needed assets for the trading day ahead. In the beginning of the day, the U.S. market also has to absorb all the news that came out of Asian and European markets and adjust, and set the tone. So just wait and see what happens by 10 a.m. EDT and then prepare and place your trade.

2. Never place a market order for an ETF. It should always be a limit order. When you do this, excepting cases involving such big names as DIA or QQQ, you leave yourself at the mercy of the seller or AP. You never know who the seller on the other end is, and your order could get filled at various and potentially unfavorable prices. Chances are that APs are not going to gouge you, because the buyers know who the APs are and the APs want to keep the reputation as being fair. Otherwise, buyers will not trust them in the long run. Nevertheless, you want to minimize your chances for making a mistake. The best way to place a buy or sell order at the ask or bid price, or within several cents of it.

3. Ignore the volume of ETFs — it is an almost meaningless measure. The trading volume that is displayed on a financial website is not relevant to buying or selling at a good price. It’s also not the best way to assess the liquidity of the ETF, which is based purely on the underlying basket — that is, the combined positions that the fund is actually holding (more on this below). If you trade through a broker, and have a significant enough position size, it is simply better to call your broker and trade live, rather than through an electronic platform. If you trade through a prime broker, the price is usually the same whether you work with a trader or use an electronic platform. But if you using a retail broker, who might charge a higher prices, the extra $20 to $30 is well worth a a better trade execution.

4. Finally, know the intrinsic value of the fund in order to gauge the right price. Before you trade the ETF, you need to assess its current value. Each fund is simply a wrapper for other securities or even other ETFs. So how does one assess the value of a fund? To do it manually you would have to know all underlying securities that are in the ETF, and you would also need the percentage (or weight) of each security. All this information is readily available on the issuer’s website.

As an example, I will look at Accuvest Global Long Short ETF (AGLS), which is issued by AdvisorShares. Here is the quick background offered by the AdvisorShares website:

“AGLS seeks to achieve the Fund’s objective by investing in long positions in the most attractive U.S. listed country-specific exchange traded funds (ETFs) combined with short positions in the least attractive country-specific ETFs. By doing this, the Sub-Advisor seeks to profit from the relative performance between long and short positions in global regions, countries, styles and sectors.”

To assess the value of the fund, I would recreate a basket of the ETF’s holdings. This one holds 10 long names and 10 short positions — all holdings and individual weights are on the AdvisorShares website. Then I would take the real-time price of each position and the corresponding weight — and, based on this information, I would calculate the ETF’s intrinsic price. This is the correct process, but obviously very cumbersome — and there is a simpler way. You can get this information on at least two websites in real time: Yahoo! Finance and Morningstar.

On Yahoo, in the “get quotes” box, type the ticker symbol, then a dash, then “IV” for “indicative (intrinsic) value.” So, for AGLS, you would type “AGLS-IV.” You can get this indicative/intrinsic value for any ETF on the market.

On Morningstar it’s even easier. The quote price includes both the last price and the indicative price, as seen on the screen grab below.

What’s really telling about the above information is that, on April 18 at 3:19 p.m., AGLS’s last trading price is listed at $21.83 at 12:30 p.m.  Meanwhile, the indicative value was $21.95, significantly higher than the last trading price. What this tells us is that the underlying value of all the AGLS holdings is actually higher than the last trade price. In fact, you can see the current bid-ask spread — near the lower right-hand corner — as being $21.88/$22. What this means is that the intrinsic value of the fund, as measured by its underlying holdings, has moved up in price by $0.12 since the last trade. This is critical information when placing an order.

I hope this sheds some light on the ETF trading process and answers some of the questions that I have been asked. If you have more ideas or suggestions, please let me know in the comments section or send me an email. Good luck trading and investing!