How to take the risk out of ETF trades

One benefit exchange-traded funds (ETFs) have over unit trusts is that ETFs can be traded throughout the day, whereas a unit trust usually has a single daily dealing point. But this also opens you up to more risks, given the computer-driven glitches we keep witnessing.

Last month, for example, Goldman Sachs flooded the US market with erroneous price quotes in share options, reportedly losing tens of millions. Shortly after, the Nasdaq stock exchange had to shut down for several hours after a price feed malfunctioned. And in the most famous incident involving rogue algorithms, the 2010 flash crash', the Dow Jones Industrial Average plunged 1,000 points in minutes before rebounding. Many stocks and ETFs saw temporary losses of nearly 100%.

Regulators' responses to these incidents are inconsistent and hint at papering over the cracks, rather than addressing root causes. After the flash crash, for example, all deals struck at prices more than 10% away from pre-event levels were busted' (annulled). Meanwhile, Goldman has reportedly managed to get 80% of its rogue options trades cancelled. But banking on a trade being torn up is foolish, particularly as exchanges' rules vary from venue to venue, and are incomplete, allowing market overseers substantial discretion after each event.

There is some protection for smaller investors, who are arguably more at risk from malfunctioning markets than professionals. London Stock Exchange allocates maximum bid-offer spread bands for London-listed ETFs of 1.5%, 3% and 5%, depending on the underlying market. Market makers cannot enter price quotes that would fall outside these bands into the exchange's order system. But market makers have some get-outs. They only have to quote prices continuously for 90% of the trading day, and can widen spreads to 25% in exceptional circumstances.

So there are two extra ways to protect yourself when buying and selling ETFs. For ETFs that usually have good liquidity, it makes sense to use limit orders' when placing trades. A simple strategy is to place your buy limit at the market's last advertised offer price (or your sell limit at the last bid price). For less liquid ETFs, phone your broker and ask for a two-way price (that is, don't immediately reveal if you're a buyer or seller). You'll pay a bit more for dealing by phone than online, but this will show immediately if the spread is abnormally wide in which case you can step away.

Paul Amery is a freelance journalist, formerly a fund manager and trader.