Because exchange-traded funds (ETFs) are different than other investments, even experienced investors should follow a few simple rules to know when to avoid trading, which type of ETF to buy and what kind of order to place.
While ETFs have some similarities to other investment vehicles, ETFs have their own terminology and rules. Investors would be wise to know the following to reap the numerous benefits that exchange-traded funds offer.
Share price is the cost to purchase one share of an exchange-traded fund. Just like stock prices, ETF prices fluctuate throughout the trading day in response to the market supply and demand.
Number of shares
Number of shares means the same as when you trade stocks. You can choose how many shares to buy and figure out your total cost. If you want to invest a specific amount in an ETF, you use the price of one share to calculate the number of shares you need to buy.
Spread is the difference between the selling price and the buying price at which ETF shares trade during the trading day. The spread is usually very narrow. There might be a penny or two difference between the buy price and the sell price. However, small exchange-traded funds can have a wide spread.
Assets are the total funds under management in a specific ETF. Small exchange-traded funds can have as little as a couple of million dollars under management. Large ETFs can have billions of dollars.
Volume means the number of shares that are bought and sold in a specific day. You should know the trading volume of any ETF you wish to buy. Trading volume will impact the spread and, consequently, the share price.
Expense ratio is the annual cost to own an exchange-traded fund. The ratio is calculated as fund’s operating expenses divided by the average dollar value of its assets under management.
Transaction fee, or commission, is a fee you pay to the brokerage firm for facilitating the transaction. These fees are usually between $7 and $10. However, you can buy some exchange-traded funds for free.
Market order means that you want to buy or sell fund shares at the best available current price. Because of the price spread, you will know the price range in advance, but not the exact price that you will pay for the shares.
Limit order means that you want to buy or sell shares of an ETF at a specific price. The broker will wait until that price is met before executing the transaction. Because of this specific requirement, limit orders are frequently not fulfilled.
Five simple rules
All brokerages offer advisory services and online research tools that you can use to choose your investments. However, to get the best price execution, you must use those tools in conjunction with some rules.
“Never buy and sell an exchange-traded fund in the first hour of trading.”
At the beginning of the trading day, prices will sometimes experience high volatility because of overnight news or aftermarket futures trading. If you allow the first hour to pass, prices will generally become less unpredictable and you will be able to get much better pricing. You might miss a few upward trends that could yield high returns. However, finding those trends is very difficult and very risky anyway. Investing in ETFs, or any other investment vehicle, is not about gambling on a few high-risk, big-return opportunities. Investing is about finding and taking advantage of many low-risk, small investment opportunities to build wealth over the long term.
“Large exchange-traded funds work better than small exchange-traded funds for most exchange-traded funds within your portfolio.”
Large ETFs have over a billion dollars of assets under management and trade more than a million shares a day. With high volumes and low spreads, large funds are easier to trade and offer more choices. Therefore, large funds work best for all but the most experienced investors.
“Know how much you’re willing to lose before you buy.”
All investments involve risk. Despite all your research and your best efforts, you will lose money on some of your investment choices. A great thing about exchange-traded funds is that you can set stop losses and limit your downside risk. Regardless of whether you trade in bull markets and bear markets, risk management is important. If you limit your losses in cases when you make the wrong choices, you will be better off in the long term.
“Look before you buy.”
This simply means that you must research the exchange-traded-funds in which you plan to invest. You should not just take a quick glance at the share price trend over the last few weeks in the five minutes before you buy. You must look at the type of exchange-traded fund, amount of assets under management, expense ratio, trading volume, holdings within the fund, etc. Be an informed investor and you will increase your chance of becoming a successful investor.
“Market orders work fine for large exchange-traded funds and limit orders are better for smaller exchange-traded funds.”
Because of large trading volumes and narrow spreads, you can always buy and sell shares of large ETFs for a price very close to your target price. However, due to low trading volume, small ETFs can have very large spreads. If you use market orders, you could end up buying shares for much more or selling shares for much less than what you intended.
If you understand how some of these basic terms apply to ETF trading and if you follow these five rules, you should be well positioned to become a successful investor in exchange-traded funds.
Doug Fabian is the editor of three publications: Successful ETF Investing, ETF Trader’s Edge, and Fabian’s Weekly ETF Report. Doug was previously known as one of America’s top mutual fund advisors, but in recent years he has made a revolutionary 100% shift to exchange traded funds (ETFs). He regularly appears at seminars around the country.