How to Buy or Sell an ETF: Real-World Best Practices

Building My Portfolio BlocksIn this ETFdb interview with Rich Powers, Head of ETF Product Management at Vanguard, there was a useful bit about the practical mechanics of buying an ETF in your brokerage account. Found via Abnormal Returns.

ETFdb: What would you say are three best practices that investors should keep in mind?

R.P.: The first is to not trade at the open or the close because the markets aren’t very deep during these times. Secondly, avoid market orders at all costs. Finally, investors need to keep their risk/return profile and expectations in mind. A retail investor will have a different set of parameters and risks that they are willing and able to bear, compared to an institutional investor, when selecting a product.

ETFs are an increasingly popular way to build a portfolio and this is good, practical advice from a respected source. I’ll expand with my own commentary below:

Do not trade near the open or close each trading day. The markets are not as liquid during these times, which means that you may get poor pricing. I’ve read elsewhere that you shouldn’t trade during the first hour or the last hour of the trading day. I’ve found this to be a good rule of thumb.

Never use a market order. A market order is like a box of chocolates… you never know what you’re going to get. A limit order simply sets a ceiling on the price you’ll pay to buy (floor on selling). A market order has no theoretical boundary, as you’re saying “just buy/sell it for whatever is the lowest/highest price available at this moment in time”. For example, if you are selling your shares and the bid on an ETF is $100.00 and the ask is $100.20, your market order could still be filled at $90 or even $50 if there is some sort of “flash crash” event. Why take that risk?

You can use a limit order that is as “strict” or “lenient” as you like. I’ve read recommendations to set a limit order for the middle of the bid/ask spread, i.e. $100.10 in the previous example. It isn’t a bad idea, but I don’t use this rule. Let’s say I’m trying to invest roughly $5,000 and thus roughly 50 shares. The difference between $100.00 and $100.10 a share times 50 shares is $5. Am I going to risk not making this buy order over $5? The market could just as easily move upwards to $100.50 as it could go down to $99.50, so any future price movement could dwarf that $5.

Since I am a long-term investor, I just want the trade to go through within a reasonable price range, so I usually choose a limit order close to the bid. Note that this padding should not be an invitation to get ripped off. I routinely get order fills above my limit price. There is an SEC rule called “best execution“. This is from a now-gone Schwab article that I’ve quoted in the past:

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.

Don’t try to time the market quotes intraday. I’m replacing Mr. Powers’ third best practice with this one, which is supported by a later quote in the interview:

[…] retail or individual investors probably do not benefit from being able to trade an ETF throughout the day.

Since you have to buy an ETF during the day, you may be tempted to delay your purchase if the market appears to be moving upwards or downwards. “If I wait, the price might go back down a bit!”… or “If I wait, the price might go up some more!”. If you are a long-term investor and not a trader, then just type in your limit order and get back to your life. Most of the time my orders fill immediately. Sometimes the market moves and it doesn’t fill right away. I usually just walk away, only to have it fill minutes later. A few times, I forget and the order expires at the end of the day. In that case, I just spend 2 minutes typing in the order again the next day. Don’t worry about daily movements, you can’t predict them anyway.

Comments

  1. I’ve heard the “avoid market order” before, but the explanation “flash crash” only applies to sells. Every paycheck I buy my 10 or 11 shares of an etf at market price. Trying to get fancy and put a cap on what I’ll pay wastes a couple extra seconds and means there’s a chance I’ll miss 2 weeks of returns if my cap is too low. Maybe I’m missing something, but for my needs–market order is fine.

    • edit: I should have noted–the two weeks stems from the fact that I’m not an intra day trader and don’t have time to sit around and see if/when my trade clears. I won’t see it until the next pay period

  2. I highly suggest only trading ETFs in tax-deferred accounts. In traditional account you’ll be receiving a K-1 every year and they’re pain to deal with a tax filing.

    • The majority of ETFs do not distribute K-1 forms. Only select ones that are organized as partnerships that with deal with commodities, currency, and funky leverage like 2X S&P 500.

  3. gabrewer says:

    At the risk of sounding naïve (and I’ve been investing 25+ years), I find ETFs to be a strange animal. Given that most are based on an index of some type, and that investing in an index fund is generally thought to be a long-term buy and hold strategy — it seems that an index-based instrument that can be traded frequently like a stock is sort of contrary to its purpose. That Vanguard is a major player in this area is further confounding to me, I understand John Bogle has been critical of ETFs.

    I do realize that there are certain cost and tax efficiencies associated with ETFs. I would be interested in knowing if there is any evidence that a typical investor does better owning ETFs over a long period — say 10 years or more — as compared to owning an equivalent index mutual fund — and particularly if the index fund is held in an IRA or other tax-deferred account.

    Having said all that, I do own a few shares of one EFT — IAU — as a means of having a small gold exposure in my portfolio. However I purchased it with an intent to hold long term, only trading for rebalancing purposes if needed.

  4. When I was a teenager, I thought I wanted to become a daytrader. I read about order entries, and the various books spoke how the most unsophisticated investors placed orders at the open and to use limit orders. I read about ECN’s etc.

    While markets have much more depth today, and the bid/ask spread is typically lower, I have seen certain spreads wide at around the open for ITOT. Buying Fidelity ETFs at Fidelity using a market order somehow always has produced pretty good entry prices ( relative to the ECN)

    So I would tend to agree with you on using limit orders, and perhaps not buying at the open. There is usually a lot of volume in the last half hour because we have a lot of funds that need to adjust positions.

    One thing I am glad is that I am not a daytrader 😉

  5. This is why I prefer mutual funds. With Vanguard Admiral shares, expenses are the same as ETFs, and they are simpler to trade.

    As far as I know, the only thing you give up is the ability to avoid the short-term redemption fee, which has never been a problem for me.

    Beyond that, the only reason I can think of to hold an ETF is if you want something very specific not available as a mutual fund, but I stick to Vanguard funds.

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