There are many reasons to like passive exchange-traded funds. They let investors access a wide range of asset classes and global markets in a single trade, while also being transparent, accessible and – on the whole – cheap.

But this ease of access can produce harmful effects if investors aren't careful, says Morningstar's Matthew Wilkinson.

Wilkinson said some investors don't appreciate that investing in a fund that trades like a stock can have implications.

Specifically, he says the listed structure means the spread between the bid and ask price of a passive ETFs can widen significantly during volatile market conditions. This means that crossing a wide spread are getting terrible prices.

So, why is this happening? Wilkinson says the answer lies in the structure of listed managed investment products and how they trade on the market.

"If you're trading highly liquid ETFs, or in benign market conditions, the bid-ask spread will tend to be pretty inconsequential, meaning that buyers and sellers generally agree about what the right price for a security should be," he says.

"But bid-ask spreads can be more onerous when you're dealing in more thinly traded securities, and their ability to maintain a narrow spread will be tested in volatile markets."

Wilkinson says this is because the bid-ask spread compensates the market maker in the security – the market middleman from whom you buy, or to whom you sell, the units in the ETF.

"The aggregate of all market participants will widen or narrow the spread depending on supply and demand ultimately," he said

"This is our issue with some listed products which means few achieve a Morningstar Gold rating, compared to traditional unlisted funds, particularly those where the market makers are the main market participant – and that's particularly the case for newer products.

"Market makers have greater knowledge of fair value than other participants."

5 tips for trading ETFs

Wilkinson says investors can overcome these trading issues if they exercise caution when using passive ETFs in their broader portfolios.

1. Avoid trading first 30 minutes or during market volatility

Morningstar's Ben Johnson recommends investors avoid trading ETFs just after the opening bell, as ETFs may take a while to "wake up" in the morning.

"For a variety of reasons, it takes some time for all of the securities in their portfolios to begin trading," he says. "Before all of an ETF's constituents are trading, market makers may demand wider spreads as compensation for price uncertainty."

Wilkinson advises investors to wait about 30 minutes after the opening bell. For similar reasons, he says investors should be on high alert before trading during volatile market conditions altogether, as this is when bid/ask spreads can widen significantly.

While Wilkinson says the impact will be felt more so by smaller and newer listed product, even large and very liquid listed products can be affected. The day of a US Presidential election, 9 November 2016, provides one of the starkest examples of a volatile trading day for most international exchanges, including the ASX.

At the start of the day, the spread – or gap between the bid and ask prices – of the iShares Core S&P/ASX200 ETF was minimal, but this blew out completely once the election result was known. Wilkinson pointed out this happened to many if not all ETFs during this trading period.

iShares Core S&P/ASX200 ETF IOZ Bid-Ask Spread, 9 Nov 2016 (Basis Points)

Morningstar ETF chart

Source: Morningstar Direct

2. Check the market depth and spread before you trade

Wilkinson encourages investors to check the market depth – a list of all the buy and sell orders in the market – and the spread before trading ETFs. This way investors can ensure they can trade the volume they want and the price they want.

For global products, Wilkinson says liquidity should be viewed before any trading as the underlying holdings may not be trading during ASX open hours.

Investors can check the depth and spread via their brokers.

3. Use limit orders wherever possible

Both Wilkinson and Johnson urge investors to use limit orders – opposed to a market order – when trading ETFs.

  • A limit order means you can set the maximum or minimum price you are willing to pay for an ETF. If the ETF is trading anywhere below your maximum purchase price, or above the minimum selling price, the trade will be executed.
  • A market order tells the broker to buy or sell at the best price he or she can get in the market, and the trades are usually executed immediately.

Johnson says limit orders help investors ensure that they are receiving favourable execution from a price perspective.

Market orders tend to be used when time is of the essence and price is of secondary importance. For very large and liquid ETPs, market orders can be less problematic when spreads are narrow, which usually indicates orderly trade, Wilkinson says. 

4. Trade with a longer-term mindset

Wilkson recommends investors use ETFs with a longer-term mindset to avoid being tempted into excessive trading. 

"A short-term outlook only increases the likelihood of an unsatisfactory result," he says.

5. Consider an index fund

If you place no value on intraday liquidity and you would prefer to forgo navigating the ins and outs of ETF trading, then an index fund tracking the same benchmark may be a better choice for you, Johnson says. 

Read this article 'Head to head: index funds versus index etfs' for further analysis.

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