Let’s say that, early one morning, you’re researching potential investments. You come across an ETF that piques your interest.
What do you do next?
Some people probably place an order first thing in the morning so they can check it off their to-do list.
Others may get busy and forget to place their order. Toward the end of the day, they rush to get it in before the 4 p.m. EST market close.
Both scenarios happen all the time. Yet, in both, the traders have made a blunder – and their strategies should be avoided.
You see, trading on the open or close of the market can be a dangerous move. There’s rarely a good reason to do so unless a major macro or sector-specific event has just occurred, and you expect it will wreak havoc on the market. And really, how often do those opportunities come about?
Why the Open and Close Are Dangerous
Generally speaking, mispricing tends to occur at the open and close of the market. Let me explain…
The market makers for each ETF typically know their holdings cold, as well as the values of these holdings throughout the entire trading day. After all, this information allows them to manage risk, profit from their activities, and provide efficient markets for the investment community.
However, it’s important to realize that not all ETFs are equally transparent. The National Security Clearing Corporation (NSCC) does provide holdings data for ETF market makers, but it only covers equities.
So if your ETF holds bonds, futures, swaps, foreign exchange, or other instruments, the managers need to rely on specialized holding files administered by the ETF sponsor. And for the most part, the formats of these files aren’t standardized. Thus, market makers could mistakenly misprice a portfolio based on low-quality data.
Even if you think that your equity ETF is devoid of such positions, the portfolio managers may incorporate them into their hedging strategy. It’s hardly a secret, either. Just read the prospectus, which will spell out what the manager may or may not hold in the portfolio.
As I said, the mispricing tends to occur at the open and close of the market. That’s because the difference (or spread) in an ETF’s intraday price and the fund’s net asset value (NAV) is often the greatest at the market’s open and close.
At the opening, market makers need to reconcile their files to ensure that valuations systems are functioning appropriately. Occasionally, a mistake occurs and monetary losses ensue. With most positions, and particularly with less-liquid ones, the bid/ask spread begins the day fairly wide and eventually narrows with volume.
Towards the 4 p.m. close, similar valuation challenges come about. For many ETFs, the cutoff time for new shares and redemptions is before the close. But let’s assume that, due to timing and liquidity issues, the exposure can’t be offset. This means that shares have to be held overnight, which creates additional hedging risk.
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Bottom line: Aim to restrict your ETF activity to a minimum of a half hour after the open or before the close.
But Wait, There’s More!
Here are a few other tips for placing ETF orders that may help you save money and improve your returns.
- For added protection, consider placing limit orders rather than market orders. This will allow you to predetermine your buy and sell levels. Then, in order to minimize losses during declining markets, consider a stop-loss order, which is triggered automatically when your ETF declines to a pre-determined price. A trailing stop-loss order will continuously increase the stop-loss price as your ETF’s price increases in value.
- Be more cautious on volatile days, as they exacerbate the likelihood of your ETF’s share price and NAV varying from the value of the underlying securities. Additionally, the bid/ask spread may widen considerably, thereby increasing your trading costs.
- Be aware that “the market” is not just the U.S. stock market. Bond markets have different holiday rules than those of equities, while the futures markets have different trading hours than both equities and bonds.
- Think globally. If your ETF has international holdings, try timing your order when those respective foreign markets are open. Of course, this may disrupt your sleeping habits, as trading hours in places like Australia, China, and Japan don’t overlap with the U.S. markets.
- Be careful of commodity ETFs that are based on a futures price of a commodity in contango. This means that, even in upward trending markets, the managers face losses on the roll yield each time they sell the nearby contract on or before expiration and buy the succeeding contract at a premium. Some managers are able to overcome the roll yield by basing the ETF on a blend of futures contracts along the curve, but this isn’t a foolproof strategy for profits.
- Aim to avoid excessive trading, which can increase your commission costs. Place your trade and go about your day. Don’t watch every tick or let market noise be an influence. If you prefer to do monthly balancing, you may want to consider certain index mutual funds that offer a similar portfolio to your ETF but don’t have transaction fees.
Basically, if you’re trading or investing in ETFs, just remember to do your homework, study the markets, and avoid executing trades on the open and close.