Auto-quote systems eliminate most of the need for hands-on attention by a market maker’s or professional trader’s staff. Consequently, even though the bid/offer spread is usually wider in a less actively traded ETF, the quote updates in the less active shares will still be more frequent than quote updates in a similarly active common stock. The frequency of quote changes is linked to the number and price volatility of positions in the ETF portfolio as well as to trading activity in the ETF shares. While the quality of the quotation services available to investors varies, it is usually possible to get a current bid and offer as well as the quantity bid for or offered for an ETF of interest. Because the best bid and offer are more useful than the every-15-second NAV proxy (that you cannot trade with anyway), the size of the best bid and offer and the spread between them are the best indicators of how many shares you can trade easily and at what price you might expect to complete a transaction. This bid and offer information is key to effective trading in the conventional ETF market.
Figure 3 shows ETF share volume by 15-minute intervals for a recent week of trading. The relatively heavy trading volume in ETFs in the first half-hour of trading both attracts and reflects retail ETF orders. A similar volume pattern in stock trading is usually attributed to institutional trading.2 There is substantial evidence that stock prices are, on average, very slightly lower in the first half-hour of trading and very slightly higher in the last half-hour of trading than over the balance of the trading day. This daily price pattern is statistically significant and is usually attributed to an artifact of institutional equity trading practices. It may not be economically significant for ETF traders, however.3 Traders who are concerned about their trading costs, especially the bid/ask spread and the ability to trade in size with minimal market impact, will usually wait until the markets in all the ETF portfolio components are open and updated quotes are available. Spreads on ETF shares tend to be relatively wide right after the opening, when the sizes of market-maker bids and offers are small. Trading is usually less costly later in the day. As illustrated in Figure 3, ETF trading volume is highest in the first hour or so of trading and in the last hour of trading.
A number of organizations and Web sites publish information on “average” bid/offer spreads for specific ETFs. Most of this information is based on data provided by NYSE Arca.4 Depending on what time of day you check the bid and offer prices and sizes for a specific ETF, you will probably find that the published “average” spread is narrower than the spread you see in actual quotes. The spread you observe is likely to be wider than the “average” spread because the published “average” spreads are weighted by the size of the bids and offers available at various times during the day. This weighting scheme means that a heavier weight is assigned to the spread at times when bid and offer sizes are larger. Larger bid and offer sizes usually coincide with times when trading volume is highest and spreads are tightest—times near the market close.
Trading in many ETFs is active between 4:00 p.m. and 4:15 p.m., but much of this trading is linked to futures markets, and bids and offers are often erratic. This trading is apparently not included in the data used to calculate the average spread. The period between 3:00 p.m. and 4:00 p.m. is generally the period when the cost of a conventional intraday trade in an ETF is lowest. This period of high volume and large bid and offer sizes largely determines the published “average” spreads. This is when the average spread on the S&P 500 SPDR (NYSE Arca: SPY) will be less than a penny—temporarily “locked” markets in the most actively traded ETF shares are common. Even if you are planning to trade shares in one of the most actively traded benchmark index funds that appear regularly on the most active list, the end-of-day period is almost certainly the best time to enter your ETF order, assuming that trading cost minimization is a significant objective of your trading plan and you decide to use the conventional ETF trading process.