As someone who spends far too much time scrolling through investing forums, it’s hard not to notice a clear imbalance in what captures people’s attention. There seems to be an endless appetite for the ‘what to buy’ content with little regard towards how to trade.

The way ETFs are structured means that the details matter far more than we realise. Below area couple of things to check before you click that button.

Understanding spreads and liquidity

When you’re selling an investment, it’s easy to focus on the headline price and brokerage, whilst overlooking some of the quieter costs that sit around a trade. One of the least visible is the bid-ask spread. This refers to the difference between the highest price a buyer is willing to pay and the lowest a seller is willing to accept. Whilst a seemingly negligible cost, it can add up quickly, especially if you’re transacting frequently.

Who sits in between these prices? We refer to them as market makers. Essentially, they’re professionals who provide liquidity and ensure there’s always someone on the other side of a trade. A majority of their profits are derived from the bid-ask spread.

What drives spreads?

Strategies like multi-asset portfolios, niche thematic exposures or funds holding obscure and illiquid securities are harder for market makers to price and hedge risk accurately. This increases the risk they take on and lowers the likelihood of them turning a profit. To compensate for this, they demand a wider spread or may even temporarily withdraw from quoting. This absence can cause spreads to widen further until market makers re-engage to restore balance.

Bid-ask spreads are usually tighter when things are calm and pricing is straightforward. On the other hand, during bouts of instability, market makers face higher risks and consequently spreads widen.

Size and liquidity have a large influence on spreads because ETFs that trade frequently are easier for market makers to manage. High volumes tend to signal investor interest and allow rapid turnover of inventory with lower risk. ETFs with larger assets under management (AUM) attract more attention from market makers and are more likely to be held in their inventories. Not only does it reduce the need for fresh creations or redemptions, but also fuels competition among market makers, lowering costs for investors and narrowing their profit margins due to tighter spreads.

How can we check liquidity?

Unlike shares or LICs, ETFs are open-ended meaning their supply expands or contracts daily through a creation and redemption process. Due to this, we can’t accurately evaluate liquidity by using the on-screen trading volume. Even if it looks like an ETF has low volume that doesn’t mean the ETF is illiquid. Market makers commonly stand ready to facilitate trades even when there’s no natural buyer or seller.

Instead, we can use ‘implied liquidity’ which is an estimate of how much of the fund can be bought or sold without causing ripples in the underlying market. This is something a fund sponsor should be able to provide. In many cases, implied liquidity exceeds reported volume by a wide margin. Ultimately, the primary determinant of liquidity is the underlying market, rather than how many units happen to be visible in the order book.

Using limit orders

A limit order lets you set the minimum price you’re willing to accept when selling. This differs to a market order which simply executes at whatever price is available at that moment.

With a market order, you’re prioritising speed and execution over control, as the sale with go through immediately without any say in the price you receive. The issue with this is that if spreads widen or the order book is thin, you can end up selling at a level that is far from the ETF’s fair value, or what you’re after.

Although it is important to note that a limit order may take longer to fill and it may not fill completely. There’s certainly a case for using either market or limit orders, it simply depends on what you prioritise.

Looking at net asset value

The price of an ETF can drift slightly above or below the value of the assets inside the fund. Most of the time the difference will be minor, but it can widen at certain points in the day or when markets are volatile. Before you sell, it’s worth taking a moment to understand whether the price you see on screen is close to the ETF’s fair value.

When we talk about a fund’s fair value, it refers to the value of all the underlying securities (asset-weighted) divided by the number of units outstanding. If the ETF holds Aussie shares, it is relatively straightforward because the underlying stocks are trading at the same time as the ETF. When the ETF holds international assets, the picture becomes more complicated, especially if those markets are closed. The uncertainty from the lack of live prices can show up as wider spreads or prices that sit slightly away from fair value.

This is where looking at NAV (net asset value) and iNAV (intraday net ass value) become useful. The NAV of most ETFs is calculated once at the end of a trading day and published on an issuer’s website. On the other hand, the iNAV updates throughout the day and provides a running estimate of what the ETF’s holdings are worth at a given time.

If you’re preparing to sell, comparing the ETF’s current price with its iNAV can be helpful. If the bid price is sitting noticeably below the iNAV, that may indicate spreads have widened, the underlying market is difficult to price or the ETF is temporarily trading at a discount. In these situations, relying on a limit order becomes even more important because it prevents you from accepting a price that doesn’t reflect the value of the underlying assets.

Picking the right time of day

ETF prices tend to be more reliable when the underlying securities are actively trading and market makers can more confidently hedge their positions.

While the market is technically open 10am to 4pm (AEST), it is recommended to trade between 10.30am-3.30pm, particularly for ETFs. The first and last part of the trading day is when ETFs are most likely to trade further from their value due to wider big-ask spreads.

At the open, ASX stocks begin trading in stages so an ETF’s components may not all have live prices yet. Market makers can be reluctant to quote prices until trading is underway for all stocks in the index. Near closing time, liquidity providers don’t want to get stuck with positions they can’t hedge until the next day. To protect from this, they widen spreads and that cost is passed on to anyone trading late in the day’s session.

If you’re investing in ETFs with global exposure, considering the underlying market timing also helps because spreads will usually be tighter when those markets are open. US and European markets don’t overlap with ASX hours so spreads may be naturally wider. But Asian markets often align with late morning in Australia.

Should you actually sell?

This article provides a discussion around the mechanics of making a sale, rather than the decision-making process behind doing so. The decision to sell an investment should be intentional and align with your long-term objectives. Shani discusses this process in depth here.

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