When trading ETFs, it pays to use limit orders

ETFs keep growing, underscoring the importance of exactly how they are bought and sold.

As the latest data from the Investment Company Institute illustrates, exchange-traded funds are way beyond just being fringe products in the investment management space, and that growth trend underscores the importance of exactly how they are bought and sold.
While the entire universe of $1.1 trillion in 1,100 ETFs is still only about a tenth the size of the mutual fund industry, the growth pattern clearly favors ETFs.
According to the ICI data through Oct. 31, ETF assets grew by 6%, while total net assets in mutual funds declined by 1.3% over the same period to $11.6 trillion.
The popularity of ETFs also is evidenced by the fact ETF shares now represents 30% of the daily trading volume in the United States, up from 7% in 2006.
The trouble is, according to Eric Pollackov, managing director at ETF Capital Markets Charles Schwab & Co. Inc., a lot of advisers and investors are still taking the easy route of trading via market orders instead of the more-precise method of limit orders.
“I don’t think most people even realize they have a choice in how they trade,” said Mr. Pollackov, a former trader.
Too often, he said, an adviser will trade using a market order that does not include restrictions on price or the time frame for the order to be executed.
A limit order, by contrast, sets a price and time frame for which the buy or sell order is open.
“A market order will guarantee a trade and a price, it just doesn’t guarantee an efficient price,” Mr. Pollackov said. “When it comes to ETFs, 90% of the time, you’re trading against a professional market maker, and when they see a market order come in they have the ability to price it wherever they see fit.”
This is especially important in the ETF space, where there could be just one market maker trading a particular ETF.
As opposed to individual stocks, “with ETFs,” Mr. Pollackov said, “you’re much more likely to be trading against a professional market maker. We advise clients to not use market orders at all.”
What Mr. Pollackov does recommend is marketable limit orders that can serve the dual purpose of executing the trade and managing the price.
For example, if an adviser wanted to buy 5,000 shares of a particular ETF that had a best-offer price of $25.10 for 200 shares, Mr. Pollackov recommends submitting a bid of $25.20 for 5,000 shares.
By bidding 10 cents over the best offer price, the limit order would buy the 200 shares offered at $25.10, along with the next-best-priced shares up to $25.20.
Submitting a simple market order for 5,000 shares would likely also get the first 200 shares at $25.10, but the buyer would have no control over how much was paid for the rest of the order.
“When I was a trader, there was nothing better than a market order, because we got to price the trade wherever we felt we could make an arbitrage,” Mr. Pollackov said.