Q: Given the fall in the stock market, I am interested in investing in Exchange Traded Funds (ETFs).  With all the volatility, I am worried about the buy-sell spread.  How do I manage this?

A:  An ETF is a managed fund that you can buy or sell on the stock exchange.  ETFs allow you to invest in a range of assets such as Australian and International shares, fixed interest, commodities and foreign currencies at a low cost with portfolio diversification benefits. Most ETFs are passive investments  that don’t try to outperform the market but rather replicate the value of an index like the ASX200 or the S&P500.  The value of the ETF goes up or down with the index or asset they are tracking.

Whilst they are meant to replicate a particular index, with price volatility and liquidity in markets at extreme levels, it is important you understand other factors that may influence price movement of ETFs outside the performance of the underlying indices they seek to replicate.

The spread is the difference in market price of an ETF between the lowest price a trader is willing to sell the ETF and the highest price a buyer is willing to pay. The wider the spread, the bigger the immediate cost when buying the ETF.  Some thinly traded ETFs have very wide spreads even if they hold very liquid assets within the ETF.

When market volatility increase, spreads in many underlying securities may also widen, and this will be reflected in the spreads of the relevant ETFs.

There are a few considerations to keep in mind when trading ETFs to help minimise the risks of buying or selling an ETF at a price that does not reflect the underlying value of the assets.

Purchase your ETF using a “price limit” not “at market”. While an “at market” order will execute the trade quickly, there is significant risk in volatile markets of executing away from what would otherwise be considered a fair buy-sell spread. “Price limit” orders give control over the price paid and can act as an important safeguard for investors against overpaying.

For ETFs with international shares, ensure you know whether the current buy-sell spread reflects market conditions.  If the offshore exchange is closed, market makers will have priced the buy-sell offers on the basis of the futures market which may not perfectly reflect market conditions.

If you are seeking exposure to an index, it is best to avoid trading in the market near open and closing times.  This is because the underlying securities in the market may not be open for trading and pricing is therefore uncertain. Market makers want to limit their risk and this may result in wider spreads and limited volume being offered in the match. As is the case with International share based ETF’s, the market makers can not set a bid and an ask price the way they can in a normal trading as they rely on futures pricing.

The major benefit of an ETF is that it allows you to invest in a range of assets at a low cost with portfolio diversification benefits. There are however negatives which need to be taken into consideration. In times of volatility take steps to minimise the risk of you mispricing your ETF trade.  Avoid trading “at market”, trading at the beginning or end of the day and recognise the risks of trading in markets that are closed and the pricing relies on the futures market.