Instantaneous access to a range of asset classes and overseas markets is one of the main attractions of exchange-traded funds (ETFs). You can buy and sell them throughout the trading day and gain one-click exposure to markets around the world. But the volatility in Japan’s markets after the tsunami has shown that this instant access can come at a price.
Compare the instant execution offered by an ETF with the slow process involved in buying a traditional mutual fund. To buy a traditional index fund, for example, you place an order before a daily cut-off point, often 4pm. Your ‘buy’ order is transacted at the end of the working day. If overseas markets are involved, your order may not be executed until the next day. In other words, you have a lengthy wait until you gain the exposure you’re looking for.
But providing instant access to markets trading in different time zones presents a challenge for ETF traders. As far as Japan is concerned, remember that Tokyo’s stock exchange operates until 3pm local time (6am or 7am London time, depending on the time of year).
That means the European market makers responsible for setting the selling (bid) and buying (offer) prices for ETFs tracking Japan cannot reference real-time prices from the Tokyo exchange during the European trading day. Instead, they use approximations, such as futures contracts (which trade almost around the clock), to determine how to adjust their ETF quotes while Japan’s market is closed. When there’s a violent move in the market concerned, trading spreads can widen, sometimes dramatically. Following the tsunami and the slide in the Tokyo exchange, the difference between buying and selling prices for some London-listed Japanese equity ETFs exceeded 10%.
Remember that the low fees charged by ETFs are a key reason for their popularity. If you’re risking a double-digit percentage cost to trade into and out of an ETF, you’re potentially giving away many multiples of what you thought you’d saved. So what should you do? Always use limit, rather than market orders (these allow you to specify the price at which you buy), to enter a new position. That way you control your execution costs. And use ETFs that employ multiple market makers. During the turmoil, those ETFs with several liquidity providers kept tighter bid-offer spreads than those with a single supporting market maker.
• Paul Amery edits
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