ETF trading tips

ETFs continue to grow in popularity among the investing public, which has advisors adding them to the range of investments they offer.

But stock pickers may have to abandon some assumptions they bring to ETFs, says Michael Cooke, head of distribution for PowerShares Canada.

“I’ve had many conversations with sophisticated advisors with strong transactional backgrounds. They know how to get best execution on stocks, but mistakenly carry that experience over to ETFs.”

The differences between the two trading processes are important, and failing to understand them can lead to missed opportunities.

Liquidity and ETF trading volume

The most common mistake is to focus on trading volume. With stocks, more volume means more liquidity, making it easier to buy and sell. Not true for ETFs.

ETF liquidity is primarily a function of the trading volume of its underlying basket of securities, says Mark Raes, head of product, BMO ETFs. “Think of the traded volume of an ETF as the tip of an iceberg; the part that’s submerged represents the liquidity of the underlying basket, which makes up most of the ETF’s liquidity.”

Focusing on ETF trading volume causes many advisors to pass over a range of next-generation products, adds Cooke.

“[Those ETFs] have smaller AUM and lower trading volume. Advisors often look at ETF trading volume and quickly dismiss them on that basis.”

Cooke explains a well-built ETF will be based on an index that’s readily investible. “Traditional indexes are proxies financial professionals use to gauge how a particular market is performing,” he says, “but they’re not necessarily designed to be investments in and of themselves.”

Consider the Russell 2000 Index, which measures U.S. small-cap equity performance; such a large universe of securities is difficult to replicate in an ETF.

“Imagine trying to buy and sell 2,000 small-cap stocks in the middle of the trading day. Many don’t even trade every day,” Cooke says. “It undermines some of the benefits of an ETF if the underlying basket is not investible.”

While many newer ETFs are less actively traded, in many cases their index methodologies assign more importance to the liquidity of the underlying basket.

“That’s the ultimate determinant of how liquid the ETF is and how good your execution will be. A well-built index will have a manageable universe of securities, and use a liquidity screen to help ensure tradability,” says Cooke.

He adds IIROC advisors don’t always have the in-house analytical wherewithal to get precise measures of the underlying liquidity of an ETF.

“But speaking with a market-making desk or ETF provider will give them a good sense of how liquid the basket is and how it will impact their ability to buy or sell,” he adds. (For more on this, read “Price setting of ETFs”).

How and when to trade

Advisors should use limit orders, which let traders maintain control over purchase price, rather than market orders.

“If an ETF is currently trading at $25 and you put in a limit order to buy at $25.01, you’ll only get executed on $25.01 or better. The same is true on the sell side: it sets the lowest price at which your units will sell,” says Dean Allen, head of product management for Vanguard Investments Canada.

Market orders are the opposite—time, not price is the priority. The order will be filled if the shares are available but there’s no price protection.

“Depending on where you are in the trading day and the volatility of the underlying basket, your execution price may be nowhere close to the posted best bid-offer,” Cooke explains.

“You might want to buy 5,000 shares, and your trading screen says there’s a one-cent spread. But there may only be 1,000 shares available at that spread, so your order won’t get filled. You have to look deeper into the order book to get a sense of where the trade will get filled,” Cooke says.

And trade ETFs when the market for the underlying basket is open.

“Any time a market isn’t open, the market maker is going to have to cover his risk because he can’t buy the underlying stocks in real time,” says Brandon Clark, a manager in Vanguard’s Equity Investment Group. “This could result in wider bid-ask spreads or greater premiums or discounts.”

This risk can take many forms. Say you buy a Nikkei-traded ETF at 10 a.m. EST. Eleven hours will pass before the market for the underlying basket opens, and events like natural disasters or elections can happen in the interim and impact the basket price when the market opens.

“If your goal is to get as close as possible to the value of the underlying securities, hold off trading Asia-Pacific ETFs until 3 p.m. EST. Anything with a predominantly European exposure should be traded before 11 a.m.,” says Clark.

Commodity markets have their own trading hours. For instance, gold futures stop trading in the open outcry auction at about 2 p.m. EST. Electronic trading continues after major markets close, but there’s far less volume, which hampers price discovery.

That means higher trading spreads. “To get best execution, it makes sense to trade the ETF when the underlying assets are available for trading,” Cooke says.

During market hours ETF traders should watch for the disruptive potential of major news items, Allen stresses. They also should avoid the first few minutes after the open, and the last few minutes before the close of the underlying exchanges.

“Those tend to be the most volatile times,” Raes observes.

Some stocks in a particular basket may not begin trading the moment the market opens. In those cases, market makers estimate fair value and may widen their spread on those securities until they have more price discovery, says Cooke.

“Similarly, towards the end of the trading day a number of stocks become less liquid because they’re not as activity traded,” he adds. “This reduced price discovery translates into wider spreads on the ETF.”

Adam Butler, senior vice president and portfolio manager at Macquarie Private Wealth, says, “We generally trade from 10:30 a.m. to 3:30 p.m. This allows us to avoid the volatility and shenanigans that go on near open and close.”

He adds, “When we know the number of shares we need to trade, we send the order out at about 10:30 and ask the trading desk to apply an algorithm to its execution. We typically trade to get the TWAP [time-weighted average price] over the course of the day.”

Show your hand?

To ensure large orders get filled, advisors often consult with market makers to determine where to set limit orders. But some advisors find this creates a dilemma—they fear revealing their intention to buy a large block of shares will give the ETF market maker incentive to widen his spread.

Butler says the best way to approach market makers is to ask for multiple two-way bids and offers on the order.

“Say you want to sell $50 million worth of ETF units. You don’t want to show your hand entirely. You want them to know you have $50 million of an ETF that you want to either buy or sell; but don’t reveal which of the two you want to do.”

Advisors should have two or three market makers give them two-way quotes—their best bids and offers for the trades they want to execute.

“If you only ask for the bid, the market maker will know you’re selling,” he says. This opens up the possibility of a suboptimal price.

Michael Philbrick, senior vice president and portfolio manager at Macquarie Private Wealth, says, “I don’t gain anything by revealing whether I’m buying or selling. If I tip my hand, I’m not going to get a better fill on the order; but I can get a worse fill if I reveal my intentions,” Philbrick says.