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

One of the features that long-term investors like most
about exchange-traded funds is that each shareholder
usually pays only the cost of his or her own
fund share transactions and is protected by the ETF structure
from the cost of other investors’ purchases and sales of
fund shares. In spite of this feature, there is a great deal of
misinformation in circulation about the cost of trading ETFs
and how to trade them efficiently. This article tries to help
you evaluate the quality of ETF markets and keep your ETF
share trading costs low.
Trading ETFs Is Different Than Trading Stocks
A natural reaction to the title of this article is, “Why
bother to write about trading ETFs? They trade “just like a
stock.” In fact, the reason for writing this article is that ETFs
don’t trade like stocks. ETF markets behave differently than
stock markets, and ETF shares trade differently than stocks
in a number of ways.
Figure 1 lists some of the similarities and differences. To
illustrate one difference, ETF investors have learned that
ETF bids and offers usually change much more frequently
than stock bids and offers. These more frequent changes can
make ETF investors uneasy, as they suggest that individuals
do not have as much information as professional traders have
about what the ETF price should be or what the ETF bid or
offer will do next.
Even if your only interest is in day-trading one of the
several dozen major benchmark index ETFs that trade more
than 10 million shares on an average day, the market in ETFs
is different than the market in common stocks in ways that
can affect your trading results. If you trade ETFs that are not
based on major benchmark indexes or that trade fewer than
10 million shares a day, ignoring the significant differences
between ETF and stock trading can be very costly.
This article will help investors find level stretches of the
ETF playing field where professional and amateur traders
have equal footing—and avoid the slippery slopes. Once you
understand how the ETF market works, and how trading
ETFs differs from trading stocks, you will be able to trade ETF
shares confidently and efficiently. In fact, with the introduction
of net-asset-value-based trading in ETFs, trading ETFs
can be much simpler and less stressful than trading stocks. 1
While the focus of these comments is on U.S.-listed ETFs
holding U.S. common stocks, many of the observations apply
to European and Asian ETF markets and to U.S. ETFs with
other portfolio holdings.
The entry in Figure 1 that generates the most questions
from investors is the trading hours for ETFs. Trading after
4:00 p.m. presents both opportunities and hazards to ETF
traders. Trading in ETFs is active until well after 4:00 p.m.,
partly because the major benchmark index ETFs (such as the
S&P 500 SPDRs, the iShares Russell 2000 Index Fund and
ETFs tracking a number of other popular benchmark indexes)
are part of major arbitrage complexes. These arbitrage complexes
typically consist of an index that serves as a template
for index mutual funds and other indexed portfolios and for
a variety of index derivative financial instruments, including
index futures contracts, index options and, of course, index
ETFs. The arbitrage complexes also include derivatives on
these derivatives, such as options on futures, options on
ETFs and securities futures products (single “stock” futures)
on ETFs. There are also exchange-traded and over-thecounter
structured products and risk management contracts
linked to many of these indexes.
Until the NYSE acquired the Amex in 2008, ETFs—like
most of the other tradable components of the index arbitrage
complexes—traded in a regular session that lasted until 4:15
p.m. to provide a structured ETF market that was fully con-
Figure 1
Some Key Differences Between Stock Trading And ETF Trading
Stocks
ETFs
Trading Hours
9:30 am − 4:00 p.m.
9:30 am − 4:00 p.m.
With substantial post-close trading until 4:15 p.m.
Net Asset Value Determined − 4:00 p.m.
Closing Price Determined 4:00 p.m. 4:00 p.m.
Market-on-Close (MOC) Rules to
Offset Order Imbalances
Yes
Yes
Volume Concentrated
First Half Hour, Last Hour
First Half Hour, Last Hour
(More Extreme)
Share Value Determined Stock Market Stock Market
Share Price Determined Stock Market ETF Market
Share Value Published Every Stock Trade Every 15 Seconds
Share Price Published Every Stock Trade Every ETF Trade
Share Bids/Offers Published Every Time Quote Changes Every Time Quote Changes
Frequency of Quote Changes
Loosely Linked to Trading Activity
Derivative Auto Quoting Loosely Linked to
Trading Activity, Volatility and Number of Issues
in the ETF Portfolio
www.journalofindexes.com July/August 2009 25