4 Mistakes To Avoid When Trading ETFs

It is always a good idea for investors who are getting used to the structure of exchange-traded funds to review some common trading mistakes. That way you won’t fall into the same pitfalls that even large professional traders have been known to make.

While most ETF trading falls into a similar category as individual stocks, there are some definable nuances that must be addressed to successfully buy and sell these vehicles. After all, the costs associated with slippage, liquidity, or incomplete information can immediately put you at a disadvantage and are easily avoided.

1. Purchasing an ETF at an exorbitant premium

The common perception of ETFs is that they are highly liquid instruments that trade frequently throughout the day by creating and redeeming shares as necessary. This typically leads to the funds market price trading tightly to its underlying net asset value (or NAV).

Nevertheless, there are numerous instances of smaller ETFs with market prices that have dislocated from their net asset value. These are often times the result of poor assessment, infrequent trading activity, foreign market participation and other factors. Currently ETF.com lists over 100 ETFs trading at a premium of 0.80% or more from their NAV. If you purchase these funds at the market price, you are immediately paying a higher cost than the true value of the underlying securities.

2. Executing a large market order on a thinly traded ETF

Often times the same funds that are trading at a large premium are also very thinly traded, which can lead to poor price execution when entering buy or sell orders. There are a number of variables that can impact ETF trading liquidity including the average daily volume on the fund itself as well as the ability for the ETF issuer to price the underlying securities.

Experts recommend examining both components of a fund if you are unsure about liquidity constraints in a smaller ETF. Heavily traded ETFs such as the SPDR S&P 500 ETF (SPY) or PowerShares QQQ (QQQ) are seeing order flow that exceed hundreds of thousands of shares per hour and won’t require the same level of analysis.

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