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.