Key Takeaways
- Understanding the structure, fees and liquidity of an ETF can be essential for aligning it with your risk tolerance and investment goals.
- Using limit orders and trading during midday hours can help reduce costs and avoid market volatility when trading ETFs.
- Monitoring the net asset value (NAV) and understanding the role of authorized participants can help prevent buying ETFs at a premium or encountering liquidity issues during market stress.
Exchange-traded funds (ETFs) have grown in popularity as one of the most flexible and accessible investment vehicles available today. Offering a blend of stock-like liquidity and mutual fund-like diversification, ETFs can serve as a core component in the portfolios of both novice and experienced investors. However, as with any financial product, we believe that successfully trading ETFs requires knowledge, discipline and strategy. Below are some best practices to help you seek to optimize your ETF trading efforts.
1. Understand the ETF You’re Trading
Before jumping into any trade, it’s crucial to thoroughly understand the ETF you’re considering. ETFs come in many varieties, including equity ETFs, bond ETFs, commodity ETFs and sector-specific funds. They may track broad indexes, focus on specific sectors or be highly specialized niche funds. Key factors to evaluate include:
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Holdings and Strategy: Make sure you understand what the ETF holds and its investment strategy. Are you comfortable with the level of risk?
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Expense Ratio: ETFs have varying fees that can eat into your returns over time. Compare the expense ratio to similar funds.
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Liquidity: Highly traded ETFs tend to have narrower bid-ask spreads, reducing trading costs. Ensure there’s enough volume to execute your trades efficiently. Trading information, including liquidity metrics for WisdomTree funds, can be found on our fund overview page.
2. Watch the Spread: Use Limit Orders
ETFs trade throughout the day just like individual stocks, so their prices fluctuate. One critical aspect of trading ETFs is the bid-ask spread, the difference between the price at which buyers are willing to buy (bid) and sellers are willing to sell (ask).
To mitigate the cost associated with wide spreads, try to avoid using market orders, which can result in buying at an inflated price or selling at a depressed price. Instead, try to use limit orders, which allow you to specify the price at which you’re willing to buy or sell. This may help you control your costs and avoid overpaying.
3. Trade ETFs during Market Hours
ETF prices can be influenced by the prices of their underlying assets, particularly in international or sector-specific ETFs. Trading ETFs right after the market opens or just before it closes can be risky due to price volatility and wider spreads during these periods. We believe the best time to trade ETFs is typically midday, when the markets are more stable, spreads are narrower and the underlying assets have already been priced in.
4. Pay Attention to NAV (Net Asset Value)
ETFs are designed to track the value of a basket of underlying assets, and the net asset value (NAV) represents the value of the ETF’s holdings at any given time. However, the price of an ETF may not always reflect its NAV exactly, especially in volatile markets. Premiums occur when an ETF is trading above its NAV, while discounts occur when it’s trading below NAV.
To avoid overpaying for an ETF, check whether the price is trading at a premium or discount relative to its NAV. While occasional small discrepancies are normal, large gaps can suggest market inefficiencies or liquidity issues that may affect your returns.
5. Understand the Role of Authorized Participants (APs)
Unlike mutual funds, where shares are bought and sold directly from the fund manager, ETFs trade on the secondary market. Behind the scenes, authorized participants (APs) create or redeem shares based on demand. This process helps keep the ETF’s price in line with its NAV. However, during times of market stress, APs may temporarily pull back from the market, which can lead to liquidity issues. Being aware of this dynamic can help you better understand potential pricing anomalies.
6. Use Tax-Efficient Strategies
ETFs are generally considered more tax-efficient than mutual funds, thanks to the creation and redemption process involving in-kind transactions, which helps minimize capital gains distributions. However, we believe it’s still important to employ tax-efficient strategies:
- Hold for the Long Term: If possible, try to avoid short-term trading to benefit from long-term capital gains rates, which are typically lower.
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Tax-Loss Harvesting: Consider using periods of market downturn to offset gains in other areas of your portfolio by selling losing positions in ETFs.
Final Thoughts
ETFs are a powerful tool for building a diversified and flexible portfolio, but their versatility requires careful consideration of the factors outlined above. Whether you’re a long-term investor or an active trader, using strategies like limit orders, paying attention to spreads and understanding the intricacies of the ETF structure can help you trade more efficiently and with greater confidence.
By following some of these best practices, you can try to maximize the benefits of ETF investing while seeking to minimize potential pitfalls. Happy trading!
U.S. investors only: Click here to obtain a WisdomTree ETF prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.
There are risks involved with investing, including possible loss of principal. Foreign investing involves currency, political and economic risk. Funds focusing on a single country, sector and/or funds that emphasize investments in smaller companies may experience greater price volatility. Investments in emerging markets, currency, fixed income and alternative investments include additional risks. Please see prospectus for discussion of risks.
Past performance is not indicative of future results. This material contains the opinions of the author, which are subject to change, and should not to be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product and it should not be relied on as such. There is no guarantee that any strategies discussed will work under all market conditions. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This material should not be relied upon as research or investment advice regarding any security in particular. The user of this information assumes the entire risk of any use made of the information provided herein. Neither WisdomTree nor its affiliates, nor Foreside Fund Services, LLC, or its affiliates provide tax or legal advice. Investors seeking tax or legal advice should consult their tax or legal advisor. Unless expressly stated otherwise the opinions, interpretations or findings expressed herein do not necessarily represent the views of WisdomTree or any of its affiliates.
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Jonathan Steinberg, Jeremy Schwartz, Rick Harper, Christopher Gannatti, Bradley Krom, Kevin Flanagan, Brendan Loftus, Joseph Tenaglia, Jeff Weniger, Matt Wagner, Alejandro Saltiel, Ryan Krystopowicz, Brian Manby, and Scott Welch are registered representatives of Foreside Fund Services, LLC.
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