Tips On How To Trade A Less Liquid ETF

August 15, 2014

With a bit of planning and patience, even a thinly traded ETF can be responsibly bought or sold.

This article is part of a regular series of thought-leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Robyn Misiano, head trader for Boston Advisors LLC.

Although exchange-traded funds are classified as an equity product, trading them can be more reminiscent of fixed-income trading—particularly in less liquid ETFs.

For individual investors looking to buy or sell smaller amounts of shares, there’s still the traditional liquidity in the marketplace with customary bids and offers.

But for institutional investors, such as Boston Advisors, who are looking to buy and sell larger lots of ETFs—including some less-liquid ETFs—there is more of a science than just trading a market order. And, our end-goal for trading is always to ensure the best possible execution price for our clients.

When we have a request to trade a less liquid ETF, the method we use closely mirrors the fixed-income trading process. Fixed-income trading is more fragmented than the equity market, and trades are facilitated through dealers by buying or selling a bond that is normally inventoried.

There tends to be some type of negotiation on price, which can depend on the size of the order, the market conditions and the price pattern of prior trades. This process highly correlates to how we trade illiquid ETFs at Boston Advisors. We use a three-stage trading approach: pre-trade analysis; trade execution; and post-trade analysis.

In this article, I’ll walk you through this process using a sample trade of a purchase of 50,000 shares of the iPath S&P Dynamic VIX ETN (XVZ | A-20).

But first, let’s start with a few trading basics.

ETF Trading Basics

When you’re trading an ETF, you have three options for execution. You can either execute in the marketplace; with an AP (authorized participant) or a market maker; or with the sponsor of the ETF.

When you trade in the marketplace, you’re buying or selling on the bid or offer and whatever liquidity is behind it in the depth of book.

When you execute the trade with the sponsor, your execution price is the closing day’s NAV. Also, there are fees associated with creating and redeeming shares, which can be up to 0.05 percent per share of the net value of the trade. When you execute with APs, they buy or sell you the ETF based on where the underlying basket of securities is trading.

Then, once the block of the ETF is executed, APs trade those underlying securities to offset their positions in the ETF, thereby replenishing their inventory.

At Boston Advisors, we prefer to trade our blocks of less liquid ETFs through an AP, because we feel we have more control on the timing of the execution, and that there are fewer fees associated with the transaction.

As the chart below shows, the larger volume most likely depicts trades that were executed by an AP, since there is no price movement—illustrated by the height of the pricing bars—in the ETF upon execution.

XVZ Volume And Price Levels

XVZ_Volume

Source: Bloomberg


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