How To Minimize Your Cost Of Trading ETFs

June 22, 2009

Figure 3

For very actively traded benchmark index ETFs (where the spread during the last hour of trading will typically be a penny, with large quantities available on both sides of the market), the location of the midpoint of the bid and offer will nearly always be close to the fair value of the ETF. Arbitrage forces and heavy trading will ensure their closeness. In the case of less actively traded ETFs where cross-market arbitrage forces do not provide much pricing discipline, the midpoint of the spread will reflect the supply/demand pressures of investor purchases and sales of the ETF shares much more than the prices in the underlying portfolio securities markets. If you are an ETF investor trying to make the same trade as other investors, you should expect to pay more than half of the posted spread on most of your trades in less actively traded ETFs.

Figure 4

If an ETF trades less than 100,000 shares a day, investor supply or demand may move the bid/ask range so that it does not even encompass the contemporary share value. In other words, the bid may be above a contemporary NAV calculation, and the spread to the NAV for a purchaser of the shares may be greater than the posted bid/offer spread indicates. Arbitrage forces are undependable when the potential for aggregate arbitrage profit is small due to lack of volume.

If you are interested in an ETF that trades fewer than 500,000 shares a day, don’t consider anything other than marketable limit orders when you are trading in the intraday ETF marketplace. If your order is larger than the number of shares quoted at your limit, expect to spend some time working the order—at best. If you are an adviser trading ETFs for a number of accounts, your broker may give you access to an algorithmic trading model that manages bids and offers relative to changes in the bids and offers for the securities in an ETF’s portfolio, much like a market maker would use.5 Even better, your broker may arrange a dialogue with a market maker in the ETF’s shares. Working with a market maker on a large transaction is usually a very good idea. The market maker can trade at lower risk if he is filling an order rather than guessing what an anonymous bid or offer might mean. The probability of repeat business with you may also favorably affect the terms of a trade.

After we take a close look at risks and costs of market-on-close (MOC) orders in ETFs, we will examine a new kind of trading in which orders can be entered for execution at or relative to the closing net asset value of the ETF. This new trading method will be particularly useful to ETF investors who want a good execution without spending a lot of time on order management and who have had unfavorable experiences with the intraday ETF market or with MOC orders for ETFs. This new trading method is important because ETF trading volume is increasingly concentrated in the most actively traded ETFs, while the most attractive investments are often in the less actively traded ETFs with wider bid/ask spreads. A trading mechanism that narrows spreads and reduces total trading costs on less actively traded ETFs can change the ETF landscape in many important ways.


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