Archives for August 2011

In recent years, Exchange Traded Funds (ETFs) have been growing in popularity when building an investment portfolio. You can buy them from any discount broker, they have no minimum purchase amounts, and offer lower expense ratios than their mutual fund equivalents. Here are some sample ETF portfolios. On a case-by-case basis, I’ve been switching over some of my holdings from mutual funds to ETFs. But a practical question arises – Do you buy them with market orders or limit orders? This is in the context of buying and holding ETFs for a certain asset allocation, not for active traders.

Briefly, a market buy order is a request to buy an ETF at the best price available at that instant that someone else is selling it for. It will usually execute virtually instantaneously. On the other hand, a limit buy order is an order to buy a specific price or lower. If you can’t get that price, it will not execute. (There are more order types, but these are the only ones I use on a regular basis.) Limit orders are useful in IRA or 401k accounts when you have a set amount of money to work with.

Why I Always Use A Limit Order

Let’s say you want to buy an ETF like Vanguard Total US Market (Ticker VTI). If you pull up a quote, the big number they will show you is the last traded price along with a bid/ask. Let’s assume the last trade is $60 a share, and the bid/ask is $59.90 and $60.40. That means at that instant, someone says they will buy X shares at $59.90 (bid), and someone else will sell their shares at $60.40 (ask).

If you put in a market order and nothing changes in the meantime (computers are constantly trading every millisecond), then you’d end up buying shares at $60.40. However, there is a chance that those shares will be sold already, and nobody else is selling at that moment except for someone who wants $75. Not a high chance, but not zero. Then you’d be stuck buying at $75.

Alternatively, you can put your limit order for whatever price you like, and see if it hits. Now, what if you put a limit order above even the current ask? You’re basically saying, I want to make a purchase right now, and I’m willing to pay a certain amount more if absolutely required. Let’s say you use a limit order at $61, a small 1% premium to the last ask. My fear would be, would someone out there see that and sell me shares at $61, even if I could get them at $60.40 or even lower? According to this Schwab.com article, you won’t be taken advantage in such a way of because such action would be illegal:

Markets are not allowed to fill orders at a price worse than the market price, even if your limit order allows for it. Building in a little extra room to ensure your order is filled will not cause you to overpay—you should still be filled at the prevailing market price when your order comes to the front of the line.

This is called “best execution”. According to this SEC article, the quality of trade executions are constantly being monitored, even on a stock-by-stock basis.

In my own personal experience, I have entered many limit orders above the market price, and my fills are usually shy of my limit price and the same as market or lower. Even though I could have easily been ripped off, I wasn’t. As a result, I don’t bother with market orders. I just use a limit order, usually with a buffer, and I get protection from a price spike or “flash crash” situation and being stuck with a horrible fluke price, while at the same time my order is likely to be filled quickly at a price no worse than a market order.

How To Choose Your Your Limit Order Price
Okay, some how much buffer do you put in? It depends on what your personal requirements are. Maybe you only want to buy at a set price, so you don’t need a buffer at all. If you really want to make a purchase today and just want to enter one order and be confident you’ll get the shares, you could add anywhere from 0.5% to 5% on top of the current market price. If you really want to make sure you get the best possible price at the exact moment you’re staring at the ticker, you can simply enter a limit order somewhere between the bid/ask spread. However, you run the risk of the price inching higher and ending up having to pay more later. According to the Schwab article above, your chances change with the size of the spread:

The wider the spread, the greater your chance of order execution between the bid and ask. The reason a market maker may be more willing to lower the ask or raise the bid in order to trade with you is that he or she knows that investors are less willing to trade at the market price when the spread is wide. By contrast, when the spread is $0.05 or less, it will be more difficult to trade between the bid and ask. In such cases, you may want to consider a limit order at the bid or ask, since shaving a penny may not be worth the risk of the order not getting executed.

Finally, the time of day matters. The time periods right when the market opens and right before the market closes are known to have higher volatility. For buy-and-hold investors, you may wish to avoid this time if possible.

Whether you invest your hard-earned money in passive index funds or actively-managed funds, the more important thing is that costs matter. Every penny you pay in mutual fund expense ratios, sales loads, trade commissions, and financial advisor fees reduces your return. Even Morningstar, a company famous for their proprietary star rating system, looked at their data and admitted that expense ratios are the “most dependable predictor of performance” and should be the “primary test in fund selection”. I like to visualize high expenses as a constant, relentless drag that is almost impossible to overcome over long periods of time. You can play with this cost widget to see how much costs eat into returns over time.

Here comes more proof. I invest a huge chunk of my money in Vanguard funds, because they offer the best selection of low-cost mutual funds around. Every year, as they get more successful, my costs actually go down as they advantage of economies of scale. However, they also offer a large selection of actively-managed funds, one of which has been around since 1928.

Data from Lipper Ratings shows that over 80% of Vanguard funds (both active and passive) have outperformed peer funds in the same categories over the last 5- and 10-year period ending 6/30/11.

You’ll find that T. Rowe Price also touts the returns of their group of funds:

Not by accident, one of their tenets of investing is low costs:

Low-Cost, Active Management
We believe in actively managing our funds and pursue a disciplined process to individually evaluate every stock and bond we invest in. But we don’t believe it should cost a lot. We keep our expenses low, so your investment can go even further. We offer over 90 funds with no loads, no sales charges, and expense ratios below their Lipper category averages.

Survivorship Bias
Making the case even stronger, by hovering over the the Vanguard chart, you can see how many peer funds there were. Let’s just take the stock funds. For the 1-year comparison, there were 10,644 funds in their peer category. For the last-3 years, that drops to 9,207 peer funds. Last 5 years, 7,562 peer funds. Over the last 10-years, only 4,035 peer funds existed.

Where did all the funds go? Sure, some funds are new, but there were lots of new funds back in 2000 as well. The fact is that many older funds are unable to be compared today because they never lasted 10 years. Most likely, their performance was so low that they quietly closed down or merged with another fund. This is called survivorship bias, and means that existing funds did even better than these charts might indicate because of the dead funds that aren’t even included.