Record-breaking trading volumes in exchange-traded funds in March highlight investors’ preference for these liquid and largely resilient investment vehicles amid the severe market volatility caused by the COVID-19 pandemic.
The average daily trading volume for Canadian ETFs was $4.1-billion in March, which was more than three times the daily volume in March 2019, according to National Bank Financial Inc. Total ETF volume for the month was $91-billion, compared with $28-billion last March.
Trading ETFs requires caution and common-sense strategies in the best of times, experts say, but even more so during the current public health crisis that has devastated the global economy and is causing markets to roller-coaster.
“Guidelines become even more important when markets are volatile,” says David Kletz, vice-president and portfolio manager at Forstrong Global Asset Management Inc. in Toronto.
Below are some tips for investors to consider when trading ETFs in this challenging environment.
Do you need to trade now?
Ben Johnson, director of global ETF research at Morningstar in Chicago, is not surprised to see the spike of investors flocking to low-cost, tax-efficient ETFs as a way to maintain market exposure and retain liquidity, especially in the fixed-income realm. But they should ask the “gut-check question” of whether it’s absolutely necessary to trade in the first place. “Hopefully the answer is no,” he says. “If investors must trade, their best bet is to wait until the market simmers down.”
Elevated trading numbers at this risky time suggest investors may be rebalancing their portfolios or locking-in tax losses, says Dan Bortolotti, a Toronto-based portfolio manager at PWL Capital Inc., a firm that uses ETFs almost exclusively in its client portfolios. Mr. Bortolotti notes markets have calmed somewhat recently “but we’re still seeing a lot of volatility,” which is nerve-racking for professional and do-it-yourself (DIY) investors alike.
Watch the bid-ask spread
One of the biggest risks in turbulent times comes from a wide spread between the ETF’s “bid,” the price that someone is willing to pay for it, and “ask,” the price at which someone is willing to offer it for sale. A spread of about a penny is a typical “transaction cost” in stable times, Mr. Bortolotti says, although this can widen with low-volume ETFs and especially with volatility, which in both cases can eat away at potential returns.
“If you’re seeing a spread of 15 to 20 cents or more, you’re losing something just in the friction,” he says. This means you’ll likely pay more than the ETF’s underlying value to buy it or receive less than that when you sell it. “Keep an eye on those bid-ask spreads, and if they’re really wide, just don’t trade or be very, very careful,” Mr. Bortolotti says.
Impose a limit order
In volatile markets “you don’t want any surprises,” Mr. Bortolotti says, so it’s best to establish a “limit order” that effectively allows you to name your price with the ETF buyer or seller and get that price (or better) if there’s a sale.
“It makes sense to practise good hygiene in any market but especially if there is volatility,” says Mr. Johnson of Morningstar, who calls limit orders “the wash-your-hands of ETF trading.” He especially warns investors to avoid placing “market orders,” which are filled at any price available, when spreads are wide.
Trade in the 'meat’ of the day
Avoid trading right after the market opens or just before it closes, when market-makers are not able to calculate an accurate price and there is often more turbulence, Mr. Johnson advises. “In the meat of the trading day is typically the best time to implement your ETF trade.”
Mr. Bortolotti agrees investors may wish to “give the market a little bit of time to warm up, especially in a volatile period,” with spreads typically narrowing mid-day. “Never place an order when the markets are closed. You take away all of your control and lose predictability.”
Be aware of what’s in the fund
It’s also important to know an ETF’s holdings and try to trade when the market for the underlying stocks is active, says Mr. Bortolotti. He won’t trade Canadian-listed ETFs that hold stock from the U.S. when markets there are closed, for example, say on U.S. statutory holidays.
ETFs holding European equities will typically have tighter bid-ask spreads in mid-to-late morning in North America because markets in Europe remain open, Mr. Kletz of Forstrong says, although he points out that there’s unfortunately no overlap between markets here and in Asia.
Consider deploying your capital slowly
Mr. Kletz suggests investors with lump sums of capital looking to jump into the current market at rock-bottom prices consider deploying the funds slowly and in smaller “chunks” over several days. This dollar-cost averaging approach is warranted today, he says, despite the additional cost of the multiple trades involved.
“From a risk-management perspective, it’s probably worth those extra commission dollars,” he says. “A bit of extra care is warranted when you’re operating in this environment.”
Get current information
When markets are swinging wildly, dealing with up-to-the-minute numbers is critical. Mr. Bortolotti warns that brokerages can have “stale quotes” that don’t reflect true spreads. He suggests that DIY investors pay for the “Level 2″ quotes that the pros use, which are more current and offer more market depth.
“The details change more quickly during volatile markets, by definition,” he says. “It becomes more important to have better tools at your disposal.”
Limit your emotions
It’s important to think things out in these extraordinarily stressful times, Mr. Kletz says. “Our daily lives have been upended … It’s very difficult to act prudently and rationally,” he warns. “You’re at home, your kids are at home, and you see your retirement savings taking a hit. Don’t make rash decisions when you’re feeling that twinge of emotion.”
Mr. Johnson agrees it’s important to ignore these impulses but says it’s “embedded in our programming” to respond. “We’re still as a species wired to react to the rustling in the bush that may or may not be a lion that’s going to maul us.”
Is an ETF the right vehicle?
Mr. Johnson says ETFs might not always be the best option for an investor, depending on the situation and particularly given today’s turbulence. If a traditional index mutual fund is available with similar exposures, comparable fees and no concern about spreads, he says, “it might be a superior vehicle,” for example in contexts such as retirement plans where regular contributions are made.