The secret to saving on ETFs: trade not too early, not too late

Exchange-traded funds are hugely popular with conservative investors looking to minimise risk.

Exchange-traded funds are hugely popular with conservative sharemarket investors looking to minimise stock risk, but most people would never know there are better or worse times during the day to buy these products that may well save you money.

Indeed, as the ETF business in Australia has exploded over the past five years, with total investment in the area growing from $3 billion in 2010 to more than $20bn at the end of October, we still know very little about how they actually work.

As the name suggests, ETFs are fund-based investments that trade on the Australian sharemarket. (Unlike index funds, which are unlisted baskets of shares, ETFs are also baskets of shares but the vehicle itself is ­listed.)

At present, there are about 100 ETF investments available from a handful of providers such as Vanguard, BlackRock and BetaShares. ETFs aim to track the return of particular indexes and markets.

Other ETFs adhere to defined parameters and offer niche portfolios with little ongoing maintenance. Such examples are ETFs that buy high-income Australian shares, ETFs that invest in high-interest, short-term cash deposits or ETFs that invest in American stocks.

Sara Huang, principal of Forward Financial Group notes that “ETFs are cost effective with ongoing management costs typically around 0.2 per cent to 0.5 per cent, which is lower than most active managed funds which can come in at anywhere from two to five times higher”.

The reason is that ETFs are passive investments and therefore have lower overheads such as trading and research costs.

Seamus Nicol, stockbroker from Morgans Financial, agrees and adds that due to the large number of underlying stocks in each ETF, “they generally offer diversification benefits which reduce company risk”.

“For example, rather than investing in one bank stock, you could invest in an ETF made up of several banking stocks which acts to spread the risk should one bank perform poorly,” Nicol says.

But for the uninitiated, trading ETFs can be tricky as there are ­little-known practices that industry traders follow based on understanding how ETF prices are set and the role of the market maker.

In the ETF market in Australia, JPMorgan, UBS, Susque­hanna and Deutsche assume the role of what is known as “market maker”.

A market maker has two roles; first to provide liquidity so that ETFs can be bought and sold. Second, to adjust ETF prices throughout sharemarket trading hours to reflect changes in an ETF’s underlying investments.

Nicol explains the role of the ETF market makers by drawing parallels to an airport foreign exchange counter.

“The foreign exchange counter buys and sells currency to travellers and makes money from the difference in the buy/sell spread,” Nicol says.

“They continually adjust exchange rates on offer based on market movements and an ETF market maker operates in the same manner.”

Nicol further notes that “the ASX allows multiple market makers to ensure competition and as such the difference between the bid price and the ask price is not too wide”.

The ASX also offers the market maker incentives if they keep spreads tight.

Paul Chin, investment strategist from Vanguard, one of the biggest ETF providers in Australia, advises “investors should consider allowing some time to pass before trading in the morning”. Waiting at least 30 minutes after markets open allows ETF prices to settle due to the staggered ­nature that the ASX opens and the potential uncertainty due to trading halts or sharp opening gains/falls”.

Chin adds: “When sharemarkets open, the market maker may not be able to price the ETF precisely, potentially leading to wider bid/ask spreads making it more costly for the investor to buy or sell an ETF.”

In other words, if you buy at the right time when spreads are low, you can save money because you pay less for the same ETF investment. This may mean that your money is used to purchase a few more shares in your portfolio, as opposed to simply lining the pockets of the spread creators/market makers.

Similarly towards the end of the trading day, Chin says, “investors should avoid waiting until the last minutes to wrap up buy or sell orders in the afternoon, as market makers begin to limit their risk, resulting in wider bid/ask spreads and as the markets approach market close”.

Chin also advises caution when purchasing ETFs with an international focus as “prices of international ETFs typically trade with narrower bid/ask spreads when international markets are open and overlap with Australian trading hours”. Asian markets open late in the Australian morning. However, European and North American markets are not open during Australian trading hours.

The industry tip is to trade international ETFs in the afternoon while Asian markets are open and closer to when Euro­pean and US markets open.

A final point on ETFs is that they can vary greatly based on their parameters and close attention is required.

Huang says: “The composition of ETFs can greatly differ for example, on the surface there could be two high-dividend ETFs that appear to do the same thing. However, one ETF provider limits banking sector exposure to 20 per cent while the other does not, meaning the two ETFs will have widely different portfolios, characteristics and returns.”

Huang advises people to “speak with different ETF providers as they can provide a considerable amount of information about the investment philosophy, performance history and other benefits”.

And most importantly, choose you time of day for buying an ETF carefully — not too late and not too early.

James Gerrard is the principal and director of independently owned Sydney financial planning firm; FinancialAdvisor.com.au