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Four Simple Rules when Buying (or Selling) an ETF

A guide to help navigate this deceptively complex activity

Morningstar ETF Analysts 06 September, 2010 | 0:00

The world of ETF investing can be daunting to a newcomer. There are hundreds of different ETFs available to choose from, with different asset classes, sectors, countries and regions, etc., all combining to bewilder the first-time investor. But once you decide upon a particular ETF (with the help of Morningstar’s ETF Centre) and have set up an account with a broker to take your orders, the hard part is over and all that’s left is simply choosing how many shares to buy, right? Unfortunately, it’s a little more complicated than that, at least if you want to minimise your costs. But by following our four-step guide, you’ll be making ETF orders like a pro in no time.

1. Check the Net Asset Value (NAV) 
As a basket of underlying securities, ETFs are worth no more or less than the sum of their parts, or the NAV. Market makers keep ETF market prices in line with the underlying NAV through arbitrage. A discount to the underlying price spurs market makers to buy the ETF shares and sell the basket of underlying securities, while a premium prompts market makers to sell the ETF shares and use the proceeds to buy the underlying securities. The supply and demand created by this activity pushes the market price of the ETF in line with the value of the underlying securities, allowing market makers to unwind the trade and pocket their profits. Authorised Participants (AP) also keep ETF prices in line through the creation/redemption process with the ETF issuer.

However, this arbitrage activity isn’t perfect. Market makers take time to establish themselves with a new ETF. Even established ETFs with low trading volume can exhibit a slight premium or discount. Because of this, it’s incumbent on the investor to compare the market price to the NAV prior to putting in a trade request to avoid buying too high or selling too low. The indicative intraday NAV, an estimate of the ETF NAV that’s published throughout the trading day, is available from your broker or the exchange.

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About Author

Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure

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