Unlike traditional funds, exchange-traded funds (ETFs) trade on an exchange. Similar to other securities traded on exchanges, ETFs can be traded throughout the day, not just after the market closes — so what times of the day should investors consider trading? It all comes down to bid-ask spreads.
Bid/ask spreads introduce a cost to transact. Historically bid/ask spreads have been higher during the open and close of markets, so investors wishing to lessen the impact of transaction costs might want to avoid trading ETFs during the open and close of an exchange, if possible. Additionally, investors of ETFs would be wise to consider order types other than market orders, such as limit and stop orders.While market orders guarantee trade execution, a limit or stop order only executes trades at prices determined by the investor ahead of time. These types of orders prevent trades executing at prices when the market moves against investors, whereas a market order does not provide this type of protection.
Costs are also an important consideration for ETF investors. Investors tend to gravitate to the lowest expense ratios for ETFs — but there are two potential pitfalls to focus exclusively on this. First, it’s important for investors to also compare underlying exposures and investment methodologies. It can easily be the case that the return differential between two funds that is the result of different exposures or methodologies offsets the difference in expense ratios. Second, there are other costs related to ETFs beyond expense ratios. Accounting for total cost of ownership, which includes expense ratios and trading costs, should be considered as well. As an example, consider two hypothetical funds, Fund A and Fund B. Fund A has an expense ratio of 20 basis points, while Fund B charges a lower expense ratio of 5 basis points. However, Fund A has better liquidity, and as a result, the total cost of a round trip trade (buy and sell) is 1.5 basis points versus 9 basis points for Fund B. If an investor makes two round-trip trades within the year, the total cost of the two funds is equal at 23 basis points. When the investor makes fewer than two round-trip trades, Fund B is cheaper. At more than two round-trip trades, Fund A is cheaper.