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 Mark Eshman, chairman and chief investment officer of Sun Valley, Idaho-based ClearRock Capital.
As ClearRock was busy celebrating our 10th anniversary this summer, our research and trading team thought it would be worthwhile to revisit and dig deeper into the mechanics of ETF trading best practices.
We launched the firm in the summer of 2007 with an investment philosophy that embraced the use of low-cost and tax-efficient ETFs in order to create endowment-style asset-allocation portfolios for our clients.
Our hunch was that the ETF universe would continue to expand with the introduction of more funds to access previously illiquid and expensive areas of the capital markets.
Today much of what we anticipated 10 years ago has been realized. Along with more volume for many ETFs, expense ratios have declined and bid/ask spreads have narrowed. Consequently, having a set of “trading guidelines” has never been more important.
Here are a few of ours:
- Pay attention to the clock – Don’t trade during the first or last 20 minutes of the trading day, if possible. Spreads are often wider, and markets can be distorted by market-makers seeking to balance their books. Furthermore, when trading foreign ETFs such as the iShares Core MSCI EAFE ETF (IEFA), you increase the odds of better executions when those markets are open, especially London.
- Don’t look a gift horse… – There is a wealth of knowledge at your fingertips; all you have to do is ask. Talk to the capital markets desk of your ETF’s sponsor and reach out to your broker-dealer relationships. An informed trader is a better trader.
- Do your homework – How liquid is the underlying? What is the average bid/ask spread? Are the underlying markets open? How big are the creation units? What is the cost? Which broker-dealers are “axed” in which asset class? (Most of these answers are available on your Bloomberg terminal.)
- Take the trade for a test drive – Before you trade it, feel out the market. Most market makers these days have algorithms giving you two-sided quotes in seconds. See what kind of market you get in the days leading up to a trade. Anything that makes you more prepared can only help.
- Show your hand – This may be counterintuitive. Broker-dealers have fixed costs when they block trade, so they gain economies of scale by trading bigger blocks. Therefore, you might see tighter spreads by trading your full position rather than parsing it out slowly. Why? In addition to the aforementioned economies, it’s also because the broker-dealer knows there won’t be more volume to follow.
- Have an exit strategy – For as much preparation as you may make ahead of a block trade, you can’t be prepared for everything. Know what options B, C and D are if option A is not satisfactory. Like any good trader, always be prepared to walk away from the table and take another route if you don’t like the cards you’re being dealt.
- Turn up the volume – Both the ETF’s and its underlying securities’ volumes matter when it comes to how you’ll trade something. For many ETFs, you barely have to think twice to trade unless you’re moving massive size. For example, you can typically trade 500,000 shares of the Financial Select Sector SPDR Fund (XLF) with little market impact. XLF trades tens of millions of shares per day as does its underlying issues such as BAC or C). On the other hand, trading 500,000 shares of the SPDR S&P Regional Bank ETF (KRE) may require a little more care. Roughly 45% of KRE is mid/small-cap stocks. The ETF only trades a little over 5 million shares per day. Traders therefore would need a plan of attack for this investment.
As an RIA, every trade for our clients puts our reputation on the line. Our fiduciary duty places an important and often-stressful burden on us when trading ETFs. We invest in one of the fastest-growing, but also increasingly complex, segments of the capital markets. Being prepared as traders is a constant battle, but one we strive to win every day.
At the time of writing, ClearRock clients currently owned IEFA, XLF and KRE. Mark Eshman is co-founder and CIO of ClearRock, an SEC-registered investment advisor with offices in San Francisco and Sun Valley, Idaho. Contact: [email protected]. For a full list of disclosures, please click here.