Exchange traded funds (ETFs) are constructed in different fashion and trade differently than open-end mutual funds with many of those differences attributable to the creation/redemption process. Said another way, “ETF plumbing” lends itself to a variety of advantages, including plenty that are tax-related, inherent to this fund structure.
A less discussed point, perhaps because it’s implicit, is that the various order types, such as limit, market, stop-loss, etc., that are applicable to other securities are relevant in discussing in ETFs. For the purposes of this articles, limit orders will be the point of emphasis, but first a disclaimer. A buy-and-holder investor looking to buy a heavily traded ETF tracking a well-known index and one with penny-wide spreads are likely to be alright entering with a market order.
That said, there are plenty of occasions in which using limit orders to get involved with an ETF makes sense and it’s almost always a good idea to use limits when selling to guard against selling an ETF for a lower than price than is desired. Now let’s examine the broader utility of limit orders with ETFs.
Bumpy Markets Favor Limit Orders
Limit orders are always practical and valuable, but that sentiment takes on added meaning when market volatility spikes – something to keep in mind in the current environment when traders can be easily spooked by geopolitical events and White House commentary.
“Sometimes, such as in volatile markets when prices rapidly spike or tumble, the execution price of a regular limit order gets eclipsed before all the ETF shares of a planned trade have changed hands,” notes Vanguard. “That’s when a marketable limit order might be the right call. Marketable limit orders are designed to combine the advantages of both market orders and limit orders. They offer a balance between price control and speed, which can be extremely important for larger trades.”
Alright so turbulent markets make for an obvious reason to use limits, but even in sanguine times, this order is valuable to advisors. Say you’re firm needs to buy or sell or large quantities of an ETF across multiple client accounts – perhaps tens of thousands or more shares. It’s certainly advantageous to use limit orders and always do so in those situations.
(Image: Vanguard)
New ETFs Are Ripe for Limit Orders
While there’s not a specific type of ETF (equity, fixed income, etc.) that’s more conducive to limit orders than others, there are some ETF hallmarks that make limit orders that much more valuable. One is age, or lack thereof, meaning new ETFs merit strong consideration regarding limit orders.
The reasoning is simple. Not all ETFs gain traction immediately, meaning volume can be low and spreads can be wide. That’s not an indictment on those funds’ investment objectives or long-term potential. It’s just how things play out in the world of ETFs. As the chart below confirms, there’s risk in using market orders with any ETF with the risk being inferior pricing for the end user.
(Image: Vanguard)
“Those aberrant trades share a common characteristic: Each was executed using a market order that led to execution well away from the current market’s fair value only for subsequent trades to immediately converge back to fair value,” concludes Vanguard. “The teachable moment here is that, had these trades been set up with limit orders, there’s a high probability that they would have been executed nearer to or at fair value.”
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