Credit: Shutterstock photoIt is always a good idea for investors who are getting used to the structure of exchange-traded funds to review some common trading mistakes. That way you won’t fall into the same pitfalls that even large professional traders have been known to make.
While most ETF trading falls into a similar category as individual stocks, there are some definable nuances that must be addressed to successfully buy and sell these vehicles. After all, the costs associated with slippage, liquidity, or incomplete information can immediately put you at a disadvantage and are easily avoided.
1. Purchasing an ETF at an exorbitant premium
The common perception of ETFs is that they are highly liquid instruments that trade frequently throughout the day by creating and redeeming shares as necessary. This typically leads to the funds market price trading tightly to its underlying net asset value (or NAV).
Nevertheless, there are numerous instances of smaller ETFs with market prices that have dislocated from their net asset value. These are often times the result of poor assessment, infrequent trading activity, foreign market participation and other factors. Currently ETF.com lists over 100 ETFs trading at a premium of 0.80% or more from their NAV. If you purchase these funds at the market price, you are immediately paying a higher cost than the true value of the underlying securities.
To ensure you don’t fall in to this trap, research the fund’s current premium or discount at the fund company’s website. This information is readily available and will help you make a decision on whether that risk is worth taking given the opportunity to purchase a similar fund with better liquidity and pricing. There are often better alternatives in the same category or with slightly different index structures.
2. Executing a large market order on a thinly traded ETF
Often times the same funds that are trading at a large premium are also very thinly traded, which can lead to poor price execution when entering buy or sell orders. There are a number of variables that can impact ETF trading liquidity including the average daily volume on the fund itself as well as the ability for the ETF issuer to price the underlying securities.
Experts recommend examining both components of a fund if you are unsure about liquidity constraints in a smaller ETF. Heavily traded ETFs such as the SPDR S&P 500 ETF (SPY) or PowerShares QQQ (QQQ) are seeing order flow that exceed hundreds of thousands of shares per hour and won’t require the same level of analysis.
One way to ensure you won’t experience a bad fill is to use a limit order rather than a market order. This allows you to set the exact price you are willing to accept and won’t allow the trade to be executed unless you receive that level or better. If you aren’t able to get filled at a chosen price, you can make adjustments as needed to move the limit amount.
3. Entering the wrong ticker or share amounts
It may seem simplistic, but incorrectly entering the ticker symbol or share amount is one of the biggest mistakes that ETF investors make when trading. The difference between buying SPY and SkyPeople Fruit Juice Inc (SPU) is just one key stroke away. Look down at your keyboard right now and you will see how easy it would be to mistype U instead of Y at the end of that ticker symbol.
In addition, if your broker or computer tries to anticipate your order and “prefills” the symbol with a slight deviation, you will end up buying or selling the wrong security. I know of many instances where professional money managers have made this mistake and paid dearly for it.
There is also a risk that you add or transpose a digit to your desired share amount, which will impact the total value of the trade. To avoid these mistakes, simply proof read the confirmation screen carefully before you submit the order. Make sure that you aren’t entering an order under a high stress environment or in a rush, which will elevate the chances of a mistake being made.
4. Buying or selling an ETF based on a “tip”
We’ve all been in a situation where a friend or colleague has to share with you their latest investment wisdom about how “the real money is being made in biotech or solar stocks”. While that might be true, that doesn’t mean you should immediately go out and buy the iShares NASDAQ Biotechnology ETF (IBB) or Guggenheim Solar ETF (TAN).
Investing in individual sectors or industries can be a hit or miss proposition that should be approached according to your experience, risk tolerance, and objectives. In addition, it’s important to understand the underlying holdings and how they are weighted in the ETF, along with the associated expense ratio. Make sure to thoroughly research these aspects before you purchase any exchange-traded fund to avoid buyer’s remorse.
The Bottom Line
Investing isn’t easy and doing so successfully requires time, tools, and discipline. Exchange-traded funds are without a doubt one of the best investment vehicles to grow and compound your wealth over time. Nevertheless, a little extra analysis and forethought will pay off in the long run as you seek to avoid the minefield of mistakes that can trip up your portfolio.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
