How to Kill a Black Swan Remy Briand and David Owyong ...

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 underperformed
its peers, the predominance of investor orders for a
fund will probably be on the sell side for long periods.
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.
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-onclose
(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.
28
July/August 2009