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Benefits of Investing in ETFs

Nearly every week on the blog I tout the benefits of ETFs in our investment portfolios.

 

By David Fabian

In my opinion, their low-cost, liquidity, transparency, tax efficiency, and global reach make them one of the best tools for growing your wealth.  Nevertheless, they can also provide bouts of heart stopping volatility (NYSEARCA:VXX) during fast moving markets.

Monday’s drubbing showed some of the weaknesses in the intra-day trading mechanisms of ETFs.  I wrote a detailed article for NASDAQ(NYSEARCA:QQQ) about how pricing inefficiencies in ETFs can rear their ugly head in rare circumstances.

Of course, there are a variety of ways to overcome these issues by instituting limit orders for your trades.  This will ensure you only get filled at the price that you pre-determine, rather than be subject to the whims of an opportunistic market maker.

While you can certainly determine when you want your trade to be executed, there is no guarantee that it will be in the right spot.  The timing of your entry or exit point can quickly produce the sinking feeling of heartbreak or the euphoria of a home run.

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A quick example of this is the price action on Tuesday.  If you bought the opening print in the SPDR S&P 500 ETF (SPY) and rode it through the close, you are already down 4.20% on that trade in just a few short hours.  Certainly no one wants to experience that unsteady feeling, even in during periods of excess volatility.

Of course, there is always the potential that this example is reversed and you are able to jump out of the gate to a fast gain.  That is the type of profitable action thattraders are seeking to capture on a daily or weekly basis.  Yet, trading in that manner takes time, tools, and discipline that you may not be prepared to commit.

For most investors that are looking to build a position with a longer-term mindset, reducing the uncertainty and psychological intimidation of this sequence can be beneficial.

One way to accomplish this is to trade like a mutual fund – i.e. right near the market close.  This will allow you to develop a sense for how the market is moving that day and execute a trade knowing your cost basis will be established near the closing print.  That way you won’t be caught off guard by any late-day histrionics in stocks or bonds.  Volume also typically swells near the close and creates a deep well of buyers and sellers for a tight execution price.

Another way to reduce the uncertainty of intra-day volatility is by breaking your trade up into multiple parts.  This is particularly easy with transaction-free ETFs that are available through most of the major online brokers. By creating multiple blocks for a desired allocation size, you can average into a new ETF position over the course of a single day or even over a longer time frame as needed.  The same can be said for exiting an ETF as well.

The Bottom Line

There is no perfect way to time the market and at some point you just have to pick a spot and go with it.  Nevertheless, some of these simple measures can reduce the risk of intra-day volatility when trading ETFs or individual stocks.  As always, having a game plan and implementing it decisively will produce superior results.