How To Minimize Your Cost Of Trading ETFs

June 22, 2009

ETF Trading Volume Is Huge, Growing And Highly Concentrated

The growth of trading volume in the most actively traded ETFs has been nothing short of phenomenal, as Figure 4 shows. ETFs now account for more than 20 percent of U.S. equity trading volume by shares, typically more than 2 billion shares per day; weighted by dollar volume, the number is significantly higher, and has been reported as high as 35 to 40 percent on certain days.

Most of the increase in ETF volume has been in the most actively traded funds. Typically, half of the most active “stocks” each day are ETFs. The most actively traded funds are often not the most attractive investments, however.

In any event, you do not necessarily have to pay a wide spread to trade a less active ETF. Beginning with some useful “rules of thumb” for intraday ETF trading, let’s look at how ETF investors can reduce their transaction costs, particularly on less actively traded ETFs.

How To Trade ETFs Efficiently

If (1) you are trading one of the major benchmark index ETFs that trades more than 10 million shares a day; (2) the current price of the shares is consistent with your objectives; and (3) the quote spread is close to the minimum of $0.01 per share, entering a market order is generally a safe choice. However, you may want to compare the size of your order with the quoted size on the other side of the market before you push the button to execute a market order.

If the thought of entering a market order in a volatile market environment is unsettling, you can enter a marketable limit order; that is, an order to buy at the offer price or sell at the bid price currently posted in the market. This order will usually be executed in full as long as the quote has not moved away from the limit on your order by the time your order reaches the market. Given the rapid changes that are often characteristic of ETF bids and offers and the heavy volume characteristic of the last hour of trading, there is always a risk that your limit order will not be a marketable order when it reaches the market and, consequently, it will not be executed. You should compare the opportunity cost of failing to execute to the possibility of a worse price with a market order.

If an ETF trades less than a million shares per day, take a close look at the bid/offer spread, at the size of the contemporary bid and offer, and at recent changes in the bid and offer; then consider a marketable limit order—or read on for more analysis and more options.

Most commentary on the cost of trading securities suggests that the appropriate way to measure the cost of the bid/offer spread in a purchase or sale is to assume that your cost of trading will include half of the spread on the purchase and half of the spread on the sale. That is a reasonable rule of thumb when you are trading common stocks in small size. However, it is not safe to assume that an inactively traded ETF’s current value is between the bid and offer in the intraday market. Most investor orders to buy or sell shares of an ETF on a given day will be on the same side of the market. If a fund has just been introduced, has enjoyed favorable commentary in the financial press or is being actively purchased by advisers for their clients’ accounts, most investor orders will probably be on the buy side for days or weeks at a time. In contrast, if a particular market segment is out of favor or a fund has under-performed its peers, the predominance of investor orders for a fund will probably be on the sell side for long periods.



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