Market-On-Close Transactions In ETFs Can Be Surprisingly Costly
There is a great deal of misunderstanding about how MOC transactions in ETFs work. This section probably contains a great deal more information on these transactions than most investors will want, but any investor who considers using ETF MOC orders will find a careful reading of this material worthwhile. The principal message of this section is that a MOC execution in an ETF will not necessarily be priced at or even very close to the midpoint of the indicative bid and offer published on the fund’s Web site and in its prospectus.
Reported ETF Premium And Discount Pricing
As a prelude to an examination of MOC orders, it is important to understand what the information on premiums and discounts published in fund prospectuses and on fund Web sites means. ETF issuers collect information on ETF share bids and offers on the listing exchange market each day at 4:00 p.m. and compare the midpoint of these quotes with that day’s NAV calculation for the ETF. Premium and discount tables or graphs reflecting these comparisons are published in ETF prospectuses and annual reports. They give investors and the SEC inappropriate comfort that end-of-day ETF transactions occur very close to NAV. Market makers in even the most thinly traded ETFs understand that the midpoint of their daily 4:00 p.m. quote will be preserved in prospectuses and on ETF Web sites for years. Market makers have a stake in drawing traders to the ETFs they trade. Consequently, they monitor their real-time bid/offer NAV calculations very closely as 4:00 p.m. approaches. Even if they have to widen their spread for a few seconds, they will work to get the midpoint of their bid and offer as close to the expected 4:00 p.m. NAV6 as possible. Their 4:00 p.m. quote is the most widely scrutinized and least useful bid/offer of the day.
Publication of premium and discount information based on 4:00 p.m. ETF share quotes has led to overuse of MOC orders, especially for some ETFs that are thinly traded. Most investors do not realize that MOC transactions in ETFs are not reflected in most ETF-reported premiums or discounts in any way. Nonetheless, MOC orders are often used by individuals and defined contribution retirement plan investors who are accustomed to mutual fund trades at net asset value and to MOC orders on stocks.
MOC Orders For Most ETFs Are Not Likely To Be Executed At Or Even Near NAV
ETF market-on-close orders often result in executions at a much greater distance from the fund’s end-of-day NAV than the reported premium and discount data leads investors to expect.
Market-on-close orders both in stocks and ETFs are integrated with the limit order books for these securities. The hypothetical schedule of bids and offers (limit orders) for an ETF at the end of the trading day displayed in Figure 5 will help illustrate how this integration works. In this limit order book, the best bid is for 2,000 shares at $24.90, and the best offer is at $25.10 for 2,000 shares. The MOC book will operate alongside this limit order book with buyers and sellers entering market orders of various sizes for execution at the close. If the balance of the MOC orders is to buy 4,000 shares of the ETF at the market-on-close and the limit order book matches the table, all the MOC orders will be filled at $25.30, unless a market maker or a last-minute customer order improves on the $25.30 offer. The lowest price at which an order to buy 4,000 shares can be filled is $25.30, and market rules require that all 4,000 shares trade at that price.
Until the official trading close for ETFs was changed from 4:15 p.m. to 4:00 p.m., MOC orders for ETFs were not subject to the same rules as MOC orders on stocks. Now, all MOC orders are accepted until an exchange-specified cutoff time for such orders, usually 3:40 p.m. After that time, orders to trade at the market-on-close will be accepted only on the side of the market that will reduce any trade imbalance. Specifically, if the balance of market-on-close orders is to buy 4,000 shares of XYZ and the limit order book looks like Figure 5, additional MOC buy orders will not be accepted after 3:40 p.m. Market-on-close sell orders will be accepted to reduce the imbalance. Regular trades will interact with the limit order book until 4:00 p.m.
These MOC rules work for very actively traded ETFs because active trading in index instruments attracts arbitrageurs. Market-on-close orders for less active ETFs often lead to trades far from NAV because the order book is sparse and because market makers tend to widen spreads at 4:00 pm. Less actively traded ETFs are not subject to continuous monitoring by arbitrage-motivated traders.