ETF trading – An advisor’s best practices guide

Trading exchange traded funds (ETFs) may seem straightforward, but understanding ETF trading mechanics is vital to ensure smooth execution, minimize cost, and align the proposed strategy with clients’ goals.

Here are some key considerations for advisors when buying and selling ETFs. These may help to avoid potential pitfalls.

Assess ETF liquidity

ETF liquidity comes mainly from two components: 

1. the trading volume of ETF units on an exchange
2. the liquidity of the individual securities held within the ETF’s portfolio 

ETF liquidity stems from two sources:

• Primary market - where ETF units are created and redeemed
• Secondary market - where investors buy and sell units on the exchange, similar to stocks

Daily trading volume is important – but so are other aspects

It’s important to note that high daily trading volume isn’t the most accurate measure of an ETF’s liquidity, unlike with individual stocks. Instead, an ETF’s liquidity is determined by the underlying securities it holds and how easily those securities can be bought and sold without affecting their price - not by its assets size or trading volume. Looking at the historical bid/ask spread will help to determine an ETF’s liquidity. 

For example, if you want to buy an ETF unit for $20, but the nearest ask price is $20.25, the bid/ask spread is $0.25. But if the ask is $20.05, the spread is only $0.05.

A narrower bid/ask usually signals greater ETF liquidity, even if the ETF itself trades infrequently. Many Canadian-listed ETFs hold underlying securities that are highly liquid, no matter its disclosed volume. Remember, the last recorded price reflects the most recent transaction, not the ETF’s current value. The real-time value is reflected in the ETF’s bid/ask spread.

Large ETF trades can be executed efficiently if the underlying basket of holdings is liquid. For large trades, consider using a block trading desk to potentially access tighter spreads and better pricing. Also, consider contacting the ETF provider’s sales desks for trade assistance, on trades worth $1million and over or for niche ETFs.

Be mindful of trading hours

The first and last 30 minutes of the trading day are often the more volatile times to execute ETF trades. Consider avoiding these periods when placing trades.

Since ETF prices are determined by their underlying securities, a delay can affect ETF pricing. Trading near the close of the day introduces the risk of partial order fills due to price movements in the underlying securities.

Also, if you trade an ETF that’s from a country outside of Canada or in a market in a different time zone, aim to trade when these markets are open and the underlying securities of the ETF are also traded. This will help ensure that the ETF price is in line with its net asset value (NAV), as global ETFs might experience pricing inefficiencies outside their underlying markets’ trading hours.

Use limit orders - and monitor them

Given the importance of spreads in ETF trading, using limit orders will allow you to set a specific target price for buying and selling. This adds control and helps avoid unfavourable pricing.

Market orders can expose clients to slippage and wider spreads, especially in low-volume ETFs or during volatile trading periods. Instead, limit orders protect pricing by setting a maximum purchase price or a minimum sale price.

Consider using limit orders to protect against price dislocation, especially during the first and last 30 minutes of the trading day. This is particularly relevant for ETFs that track indexes with lower trading volumes or wider bid-ask spreads, especially in sector-specific or thematic ETFs.

Consider tax implications

As an advisor, you must assess an ETF’s tax structure and implications based on the client's account type and investment horizon.

Advisors must be aware of:

• Capital gains distributions: Even passively managed ETFs can trigger taxable events through rebalancing or index changes.
• U.S. withholding tax: Canadian-listed EFTs holding U.S. securities may incur U.S. withholding taxes on dividends received. This can, potentially, lead to double taxation when these taxes can't be recovered by Canadian unitholders.
• Currency hedging: Some ETFs offer Canadian dollars hedged and unhedged versions. The hedging can impact returns and tax treatment depending on market conditions.

Watch for premiums, discounts, and NAV tracking

While Canadian ETFs generally trade close to their net asset value (NAV), deviations can occur, especially during periods of market stress or when underlying securities are less liquid.

To monitor ETF pricing more effectively:

• Refer to intra-day NAV (iNAV) if available
• Use ETF provider tools to assess real-time NAV estimates
• Be cautious during earnings releases or macroeconomic events that could temporarily widen spreads

As an advisor, you may also want to evaluate the trading costs and the associated fees of an ETF. You may want to consider:

• Bid-ask spread: Often a hidden cost that can exceed commissions, especially in thinly traded ETFs.
• Tracking error: Small but persistent underperformance relative to the benchmark can impact long-term outcomes.
• Foreign exchange (FX) fees: For ETFs traded in USD on a Canadian platform, FX fees may apply.

• Explore our ETF Series line-up of funds
• Share this article with clients - What is an ETF? Essentials to know
• Read this insight - ETF Series vs mutual funds: key differences for Canadian investors