How to get the most value from ETFs

Australia's financial regulator, the ASIC, has some useful guidelines for retail investors in exchange-traded funds (ETFs) on its consumer finance website, Money Smart (Moneysmart.gov.au). These outline some basic due diligence that anyone thinking of buying an ETF should follow.

One risk that ASIC notes is the possibility of price gapping'. This is the risk that an order to buy or sell an ETF is executed at a price that's some distance from the fund's intrinsic value. Given that a key advertised attraction of ETFs is their smaller management fees, it makes little sense to cut costs in one way, then risk giving up those savings by getting a bad purchase or sale price.

The risk of doing so is real, unfortunately. Data from the London Stock Exchange show that the average bid-offer spread (the difference between a fund's selling and buying prices) for ETF trades rose during August's market sell-off to more than 2%, more than three times the level in July, and well over the average ETF fee.

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In some cases average spreads even hit double-digit levels, although that may have been skewed by periods of high volatility when ETF market-makers stopped quoting prices altogether.

The risk of getting a bad dealing price may not be so acute in the most popular products, such as iShares' FTSE 100 tracker (ISF) or ETF Securities' Physical Gold ETC (PHAU). These typically command a spread of under 0.1%.

But for many ETFs offering exposure to less liquid sectors emerging markets indices, global theme-based benchmarks, and leveraged indices seem to feature prominently among the trackers with high trading costs there's more to worry about.

So what should you do? First, check stock exchanges' websites for historical bid-offer spread data, looking at how funds have traded during more and less volatile market periods. Second, choose funds that have multiple official market-makers, which should help ensure better liquidity.

Third, try to find a live price feed that gives the ETF's indicative net asset value (or iNAV), which represents an updated, intraday measure of intrinsic value. Finally, try to use limit orders (where you stipulate a specific buying price), especially when entering a new position. By doing so, you can control costs and make sure you buy a fund on your terms.

Paul Amery edits www.indexuniverse.eu , the top source of news and analyses on Europe's ETF and index-fund market.