Pension fund managers considering expanding their use of exchange-traded funds must always bear in mind that trading ETFs is entirely different from trading stocks.
Entering a transaction without a clear understanding of the market dynamics for the ETF and the underlying stocks can be costly without the right precautions. The market impact can be more than the fee in basis points cited in the funds' materials.
“The implementation of a trade is very important and, in some cases overlooked,” said Tim Coyne, head of ETF capital markets for State Street Global Advisors in New York. SSgA sponsors nearly $300 billion in U.S. exchange-traded products.
Only in the past few years, with the surge in ETF issuance and trading, have market makers and institutional agency brokers begun to offer ETF-specific implementation shortfall models.
“While the depth of the limit order book for an ETF tends to be much deeper than for common stocks, liquidity is also more volatile,” said Milan Borkovec, managing director and head of financial engineering at ITG in Boston.
This volatility is because new ETF shares can be created relatively quickly by a market maker known as an authorized participant, which sources all of the underlying securities and delivers them to the fund custodian in exchange for new units of the ETF. These transactions are processed at the end of the day as creation units, which generally represent 25,000 to 50,000 shares of the ETF.
In an October paper entitled “Create or Buy,” ITG analyzed 12 popular ETFs and incorporated the cost estimates for trading the underlying basket to get a better understanding of the true cost of execution for a large ETF order in the course of a trading day. The paper focused on ETFs holding U.S. stocks ranging, from highly liquid standard bearers SPDR S&P 500 (SPY) and the iShares Russell 2000 (IWM) to the relatively liquid Guggenheim S&P Equal Weight (RSP) and the less liquid iShares Russell Microcap (IWC).
The “optimal switching point” from secondary market order to creating shares from the underlying stocks, according to ITG, can very widely depending on the characteristics of the ETF. Generally, larger orders can be more cheaply accessed through new shares at cost of 2 to 4 basis points less.
One of the selling points for ETFs is that they can be more liquid to trade than their underlying constituents, but this is only the case in a handful of funds, said Alex Hagmeyer, vice president for data analytics at Markit in Naperville, Ill.
Estimating market impact — the spread from arrival price to final price — to include the notion of ETF creations and redemptions can be complicated by market conditions. And the dynamics of ETF trading have several brokers and data analysts refiguring their implementation shortfall estimates, taking into account that liquidity in the ETF is not the same as the total liquidity available to the investor.
For pension fund managers passing through ETFs in a manager transition or when adding a liquidity layer in broad-market ETFs, market impact models may seem a distant concern but basis points on large transactions can add up.
“A lot of ETFs are quoted by market-making algorithms,” said Chris Hempstead, director of ETF Execution at WallachBeth Capital in New York. For this reason, the impulse to get filled instantaneously by sweeping the limit order book can have a negative impact on an ETF trade.
Mr. Hempstead paints a scenario of an ETF order for 10,000 shares — 1,000 shares filled at the displayed price and 9,000 a nickel away. “If the quotes fill in around your trade (back to the original price), you probably paid too much,” said Mr. Hempstead.
Push on index
Large ETFs orders executed in a short timeframe can also push on an index and its underlying stocks as well. While temporary, a holder of an affected stock might look for information on unusual volume and find no information other than the ETF activity.
In a Nov. 5 commentary on ETF trading strategy, Credit Suisse highlighted a $2.5 billion trade in two midcap stock ETFs on Oct. 1. The traded value of midcap stocks that day was 20% higher than average. A less aggressive trade would have taken more than a week to execute with market impact at 50 basis points. For one trading day, however, impact was observed at 84 basis points, in line with an 80-basis-point impact estimated by Credit Suisse EDGE Pre-Trade, part of its impact model.
Redemption of the ETF shares mitigated the impact by noon the following day, but the trader in question look some lumps to get out of such a large position quickly.
According to Matt Hougan, president of ETF Analytics for Index Universe, San Francisco, a responsible ETF trade must be calculated within certain levels of aggression, including time to completion. “You should have a sense of the maximum amount you would pay before the trade, including commissions and convenience charges,” said Mr. Hougan. This includes the cost for an authorized participant to create or redeem the basket of shares.
For a pension fund looking to either acquire or dispose of select securities or ETFs, it is worth checking with an institutional trading desk to discuss the so-called “liquidity matrix” for the trade through an ETF, said Reginald M. Browne, managing director for listed derivatives at Knight Capital Group, Jersey City, N.J.
Mr. Browne cautions that an investor may be best served by an order that is a mix of activity facilitated through both a market-maker on the secondary market and an authorized participant creating shares of the fund. Moreover, the investor may find that they could be even better served by a different ETF than the one they originally looked to buy.
This article originally appeared in the November 26, 2012 print issue as, "ETF trading choices can affect costs, execution".