Here are a few simple rules to ensure you transact at the right price when buying your next exchange-traded fund (ETF).
One of the primary determinants of long-term share performance is the price at which you buy direct shares in any listed company.
Sometimes the market throws up opportunities when you can buy shares in quality stocks for less than the business is worth, and the greater the discount, the better the returns to your portfolio over time.
However, given that most ETFs deploy a redemption mechanism called a market maker – to ensure the price remains close to its net asset value (NAV) - aka official value – it’s unusual for them to trade at the sizable discounts or premiums that ordinary stocks so often do.
But while ETFs won’t directly ride share market momentum on either an upward or downward trajectory, the underlying stocks that an ETF is invested in most definitely will.
The movement in the ETF price directly reflects what’s happening within the underlying stocks/indexes they’re invested in, and if they’re down due to negative economic announcements and uninspiring earnings reports, the ETF will typically follow suit.
However, there are times when an upswing in overseas shares won’t be directly reflected in the price of the ETF that holds them, and this can happen when there’s a corresponding upswing in the value of the Australian dollar.
When to buy an ETF
Just because ETFs deploy a market maker doesn’t mean you have to be a complete price-taker and buy at the current market price. As with any other direct shares you buy, you can place a buy order based on your nominated price limit.
Typically a price limit order will be "good for the day" and if not executed, simply drops off the system when the market closes.
Within an ETF context, you can use the NAV to determine the price at which you’re willing to buy an ETF.
But instead of using the current discount or premium as a primary determinant – as you would when buying direct shares – the entry point for ETF buyers will be determined by what’s called the buy/sell spread.
In simple terms, the spread represents the difference between an ETF’s current market price and its NAV - based on the last price when the local market (aka exchange) closes.
While it should be relatively minor, the difference between NAV and market price will be wider during times of high volatility.
When the spread is at its widest
The spread tends to be at its widest when the market opens and closes, and that’s especially true when the underlying stocks are listed on international share markets that won’t be fully updated until after the local share market closes.
For example, just prior to closing time (4 pm eastern) is when the market maker starts to balance the books, and this can result in wider spreads and increased, albeit short-lived ETF price volatility.
Similarly, when the share market opens (10 am eastern), price differences may persist until the market readjusts accordingly.
With that in mind, you’re better off avoiding placing market ETF orders during the first and last 20 minutes of any trading day.
You can place price limit orders in light of any pending NAV readjustments.