Anatomy Of An ETF Trade

What happens and what to consider when you buy or sell an ETF.

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Reviewed by: Cinthia Murphy
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Edited by: Cinthia Murphy

[This article appears in our February 2020 edition of ETF Report.]

Trading an ETF isn’t necessarily difficult—it’s pretty much the same as trading a single stock—but if you’re trading in size, you often don’t want to go about it alone. Best trading execution means working with the best players, and that requires some due diligence.

At a very high level, here’s the challenge for working big trades, summarized by an ETF trader: “You can trade an ETF as an agent on exchange; you can route your order to someone else; you can trade on algorithm [high-frequency trading firms]; or you can go over the counter and ask for a two-sided trade through a market maker—not to indicate what side you’re on, but to put people in competition for you. There’s a host of different ways to trade.”

When you’re trading an ETF, there’s no shortage of things to consider. From getting the right order type—market order, limit order, stop loss order, etc.—to getting the best price, to understanding fair value, to navigating liquidity on screen and in the underlying, it all matters. (Since ETFs are baskets of securities—be they equities, bonds, derivatives, other ETFs or a mix of all of those—underlying liquidity can play a big role in trading execution just as much as average daily volume.)

Where to begin?

Know What You Need To Know
If you’re new to trading large blocks, the first thing you’ll want to do is talk to folks. Guidance can be critical.

As an advisor, chances are that guidance will come from your custodian—the likes of Schwab, Fidelity, TD Ameritrade and others—or from your affiliated wirehouse, such as Merrill Lynch, Morgan Stanley or Wells Fargo. These firms have expert trading desks capable of handling ETF order flow and model portfolios, and can help you figure out what works in your best interest: everything from what time of day, to what type of order, to where to make your trade.

In most cases, the process goes something like this: You call your broker/custodian and tell them what ETF you’d like to trade. They punch the information into a quote screen, check out the volume traded on the day—as well as bids and offers available from various dealers—and tell you what they see.

“For the majority of ETFs, you’re going to see several hundred shares at various price levels every day,” Paul Weisbruch, head of  ETF sales and trading for New York-based GTS – Mischler, said. “It’s very efficient. You could put a fair amount of money to work without high-level assistance from anyone, quite frankly, because there’s plenty of screen liquidity.”

With or without the help of a custodian, trades of highly liquid ETFs can be a one-stop process. You can either trade on your own, or you can tell your affiliated wirehouse what to buy, and they’ll get you the best price available through an electronic order in 90 seconds or less. What’s more, in most cases today, ETF trading now happens commission free in these platforms. Simple and cheap.

But what if you’re not a Schwab or Fidelity client, or you simply need more help on a complex trade? That’s where an ETF issuer’s capital markets desk can come into play.

Every issuer has professionals standing by at their capital markets desk to talk to you about the intricacies of trading their products. They can tell you how their products compare with others in the marketplace, how they trade throughout the day and how liquid—or not—their underlying assets are. They can’t make the trade for you, but they can often provide real insight into when to trade, how to trade and even with whom.

Big Trades
But ETF trading isn’t always this easy.

Things can get more complicated if you’re looking to do a bigger trade that requires access to capital and liquidity, or if you’re trying to trade an ETF whose underlying index doesn’t trade during U.S. market hours; or if a fund has a very illiquid basket of assets.

For example, say you want to buy 50,000 shares of an ETF that trades only about 30,000 a day. You called your broker, and the numbers aren’t on your side because the volumes visible on screen aren’t anywhere near that large.

“An issue can arise if the order size exhausts what you see on the screen,” Weisbruch said. “It happens a lot with new ETFs. That doesn’t mean you can’t buy 50,000 shares; it just means the technique you’re using is going to be very important.”

Creation/Redemption’s Beauty
The next best step on this trade is to talk to market makers, who would compete on best pricing to execute your deal. Unlike your custodian, your market maker can tap the creation/redemption process (through their role as authorized participant). That means that instead of finding 50,000 shares for you, they can simply make them.

Upon seeing your bid for, say, 50,000 shares of an ETF, the market maker would do some internal profit and loss calculations, offer you a quote and sell them to you. Importantly, at that point, they don’t actually have those 50,000 shares—they’ll end up short. That’s OK; that’s how the process works.

To make up the deficit, they (or a related AP) then acquire all of the individual securities the ETF issuer requires to do a creation, and exchange those securities for the 50,000 shares they need to make good on the trade they just executed for you.

At the end of the day, they’d net zero: they’re short 50,000 shares to you, but they receive 50,000 shares from the issuer from the creation process. The ETF issuer gets an increase in assets under management, you get the shares you want, and the market maker books a small profit for facilitating the trade. This is the magic of the ETF creation/redemption mechanism. It allows for the supply of ETF shares to remain elastic, and for ETF trading to stay close to fair value, even with anemic on-screen liquidity.

In the old days, accessing a market maker required some shoe leather—or, a lot of phone calling on your part to get various quotes on your desired block of shares. Today, however, getting market makers to compete with each other on pricing on your behalf is easily done through electronic system known as request for quote (RFQ) platforms, such as that offered by Bloomberg.

In an RFQ trade, the order request goes out into an anonymous bulletin board where market participants quickly—as in seconds—respond to that request with a price quote for those ETF shares. As a trader, you simply pick the best one. Once you agree to the market maker’s price, they deliver your shares. Deal done.

The good news is that your custodian or an ETF issuer’s capital markets desk should have plenty of relationships with market makers and access to RFQ platforms, and can help connect you to the best execution for more complex trades. It still, ultimately, comes down to understanding your options.

As an ETF trader put it: “Be informed. Foster relationships, know how to go about it, when to go about it, how to benchmark it and how to evaluate it.”

Due Diligence Tips
While all of that may seem fairly “squishy” for the rather mechanical world of ETFs, there are some simple best-practices trading rules that apply regardless of how you approach your trading, according to professional traders on the Street, including:

  • Don’t use market orders
  • Carefully manage any other type of orders, such as stop-loss orders
  • In over-the-counter (OTC) transactions, put buyers/sellers in competition for best execution
  • Don’t let the market know you’re about to trade a large block of an illiquid ETF—be discreet; when possible, ask for two-sided quotes to shield your intent
  • Remember that liquidity varies at different times of the day
  • Understand how much it’d cost to unwind a position; know all your costs!
  • Know the ETF you’re evaulating, e.g., what it holds, whether it trades at a premium

At the end of the day, good trading execution goes beyond the numbers. It’s ultimately about delivering on an investment objective.

To that end, remember: Just as important as asking the “what” and “how” about trading is asking the “why.” Why are you trading that ETF?

“Am I reacting to news; has my model changed; do I have a client whose circumstances have changed?” an ETF trader said. “You have to know these answers to assess whether any of the costs involved with trading an ETF are worth it or not.”

 

Cinthia Murphy is head of digital experience, advocating for the user in all that etf.com does. She previously served as managing editor and writer for etf.com, specializing in ETF content and multimedia. Cinthia’s experience includes time at Dow Jones and former BridgeNews, covering commodity futures markets in Chicago and Brazil equities in Sao Paulo. She has a bachelor’s degree in journalism from the University of Missouri-Columbia.