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

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Figure 2 Offer NAV Proxy Bid Using The Every-15-Second NAV Proxy To Determine Bids and Offers A B C D E 15sec 15sec 15sec 15sec 15sec Time temporaneous with the futures markets. Since the change to a formal close at 4:00 p.m., ETF volume between 4:00 p.m. and 4:15 p.m. has not changed materially. On May 15, 2009, the day before this article was prepared for submission, ETFs were four of the five most active issues in after-hours trading. One of that day’s most active after-hours ETFs is based on an index that does not have an active futures contract. ETF Intraday Net Asset Value Proxies When trading began in the first ETF introduced in the United States (the S&P 500 SPDR launched in 1993), the Securities & Exchange Commission (SEC) required that the sponsors of the SPDR arrange for dissemination of an intraday share value proxy for the SPDR at 15-second intervals. These proxies are usually called indicative optimized portfolio values (IOPVs). The requirement for publishing these values was extended to every domestic equity ETF launched since 1993 and, with modifications, to ETFs holding foreign equities, fixed-income instruments and other financial instruments. In spite of improvements in trading data calculation technology and the introduction of ETF portfolios that hold infrequently traded securities, calculations of these intraday value proxies are still based on the most recent trade of each portfolio component. Matt Hougan discusses the inadequacy of last-sale value proxies in an article scheduled to appear in the July 2009 issue of ETFR. These intraday value proxy calculations are made and/or disseminated by the National Securities Clearing Corporation (NSCC) and other service providers to “support” intraday trading of ETFs. Professional ETF traders and market makers do not use the “official” every-15-second proxy value calculations to help them determine their ETF bids and offers. Professionals develop their own valuations or subscribe to real-time ETF value calculations based on contemporary bids and offers rather than last sales. The fact that they do not use the free IOPV does not mean that these professionals lack faith in the NSCC’s ability to calculate correct values. The simple facts are that the last sale is not a reliable indicator of contemporary values in most Price market situations, and the 15-second interval between valuations is too long for the values to be useful to a trader. Because an ETF is a derivative security, its current value changes every time the value of any component of the ETF portfolio changes. The ETF value proxies used by professional traders are calculated from the midpoint of the bid and offer for each position in the ETF portfolio. Sometimes the value calculations made by and for professionals use the size of bids and offers and the pattern of “changes” to forecast short-term trends. Figure 2 illustrates how a naive investor might attempt to use the “free” intraday proxy information to develop a bid or offer for ETF shares. In Figure 2, the latest IOPV is represented by a dot at the beginning of each of the five 15-second intervals illustrated. Investors might place limit orders at prices close to the most recent per-share value proxy. Columns A through E illustrate how bids and offers entered at equal distances, respectively, below and above a sequence of these every-15- second net asset value (NAV) proxy calculations might become transactions—but not always the transaction that the investor entering the order hoped to achieve. An offer to sell the ETF’s shares slightly above the proxy value posted at the beginning of time interval A would probably be lifted as the fund portfolio value rose during intervals A and B. That offer was below the changing per-share proxy value by the time that value was updated at the beginning of interval C—less than 30 seconds after the order was entered. The offer was also below the likely bid in the market at that time. Of course, some of the last-sale prices used to calculate each 15-second proxy might be more than a few minutes old at the time the calculation was made. Using the free 15-second values can be costly, but even if investors had access to proxy values based on every- 15-second midpoints of bids and offers and could enter orders as soon as the value was published, a lot can change before or shortly after the next proxy value is published. In my experience, many investors are aware of the existence of the every-15-second last-sale NAV proxy value, but few know how to find it for a particular ETF and even fewer think about how, if at all, to use it. It is probably a good thing that these proxies are not widely used. Any attempt to use them to manage an order is more likely to lead to disappointment than to a good execution. The information on share values, transaction prices, bids and offers summarized in Figure 1 indicates that ETF bid and offer updates are published more frequently than every 15 seconds (every time portfolio component bids or offers change materially), making the ETF share bids and offers a much better indication of the current market for an actively traded ETF than the every-15-second last-sale proxy calculation could possibly be. The posted ETF bids and offers also have the advantage of being something you can trade with. You cannot trade with the every-15-second NAV proxy because it does not represent a bid or offer for the ETF shares. An investor can be confident that, even if his market data vendor is a bit slower and updates quotes less promptly than the best data vendors, he will not be seriously disadvantaged relative to other retail market participants. Bids and offers for the most actively traded ETFs tend both to be tighter and to change more frequently than stock 26 July/August 2009
quotes during active trading periods. In active trading periods, spreads are frequently as narrow as a penny per share between the bid and offer for some of the most actively traded ETFs. These periods of active trading are the best time to trade ETFs. However, if trading is not active, the quotes in the market tend to reflect a wide spread between the bid and the offer. The Brave New World Of High-Frequency Electronic Trading Few individual investors have the kind of information professional traders use or the capability to change their bids and offers as fast as the quotes on an ETF share change in common market situations. Professional traders and market makers not only calculate intraday bid/offer values for ETF shares continuously throughout the trading day, they use automated quote management systems that can change their ETF bids and offers in a millisecond or so (a millisecond is 0.001 of a second) every time the bid or offer changes for any security in the ETF’s portfolio. The fact that regular-session ETF trading volume usually exceeds 2 billion shares per day is partly due to the speed of order entry and execution to capture small changes in value. The quest for speed of execution has led the Nasdaq market to boast “peak [round-trip] trading speeds of 250 microseconds” (a microsecond is 0.001 of a millisecond). In this high-speed environment, time lags associated with information traveling even a few hundred miles at approximately the speed of light confer a premium value on computer centers located within a few yards of an exchange order-matching system. If you have access to an institutional equity trading desk, ask to see an active montage monitor of the best bids and offers from all the markets trading SPY or QQQQ during regular trading hours. I have not included a static example of the montage monitor because a snapshot cannot convey a sense of the frequent and rapid changes in bid and offer prices and sizes. I have not seen comparable displays from any other activity except, perhaps, the last digit in an electronic sign showing an update of the estimated U.S. population. The census sign has only one or two high-frequency flashing digits. The montage monitor looks like a time-lapse video of a beehive. An individual investor can benefit from high-speed trading developments to the extent that they compress bid/ offer spreads in actively traded ETFs. Investors using actively traded benchmark index ETFs trade in a very efficient market thanks to high-speed trading. Auto-quote systems eliminate most of the need for handson attention by a market maker’s or professional trader’s staff. Consequently, even though the bid/offer spread is usually wider in a less actively traded ETF, the quote updates in the less active shares will still be more frequent than quote updates in a similarly active common stock. The frequency of quote changes is linked to the number and price volatility of positions in the ETF portfolio as well as to trading activity in the ETF shares. While the quality of the quotation services available to investors varies, it is usually possible to get a current bid and offer as well as the quantity bid for or offered for an ETF of interest. Because the best bid and offer are more useful than the every-15-second NAV proxy (that you cannot trade with anyway), the size of the best bid and offer and the spread between them are the best indicators of how many shares you can trade easily and at what price you might expect to complete a transaction. This bid and offer information is key to effective trading in the conventional ETF market. Figure 3 shows ETF share volume by 15-minute intervals for a recent week of trading. The relatively heavy trading volume in ETFs in the first half-hour of trading both attracts and reflects retail ETF orders. A similar volume pattern in stock trading is usually attributed to institutional trading. 2 There is substantial evidence that stock prices are, on average, very slightly lower in the first half-hour of trading and very slightly higher in the last half-hour of trading than over the balance of the trading day. This daily price pattern is statistically significant and is usually attributed to an artifact of institutional equity trading practices. It may not be economically significant for ETF traders, however. 3 Traders who are concerned about their trading costs, especially the bid/ask spread and the ability to trade in size with minimal market impact, will usually wait until the markets in all the ETF portfolio components are open and updated quotes are available. Spreads on ETF shares tend to be relatively wide right after the opening, when the sizes of market-maker bids and offers are small. Trading is usually less costly later in the day. As illustrated in Figure 3, ETF trading volume is highest in the first hour or so of trading and in the last hour of trading. A number of organizations and Web sites publish information on “average” bid/offer spreads for specific ETFs. Most of this information is based on data provided by NYSE Arca. 4 Depending on what time of day you check the bid and offer prices and sizes for a specific ETF, you will probably find that the published “average” spread is narrower than the spread you see in actual quotes. The spread you observe is likely to be wider than the “average” spread because the published “average” spreads are weighted by the size of the bids and offers available at various times during the day. This weighting scheme means that a heavier weight is assigned to the spread at times when bid and offer sizes are larger. Larger bid and offer sizes usually coincide with times when trading volume is highest and spreads are tightest—times near the market close. Trading in many ETFs is active between 4:00 p.m. and 4:15 p.m., but much of this trading is linked to futures markets, and bids and offers are often erratic. This trading is apparently not included in the data used to calculate the average spread. The period between 3:00 p.m. and 4:00 p.m. is generally the period when the cost of a conventional intraday trade in an ETF is lowest. This period of high volume and large bid and offer sizes largely determines the published “average” spreads. This is when the average spread on the S&P 500 SPDR (NYSE Arca: SPY) will be less than a penny— temporarily “locked” markets in the most actively traded ETF shares are common. Even if you are planning to trade shares in one of the most actively traded benchmark index funds that appear regularly on the most active list, the end-of-day period is almost certainly the best time to enter your ETF order, assuming that trading cost minimization is a significant objective of your trading plan and you decide to use the conventional ETF trading process. www.journalofindexes.com July/August 2009 27
Page 1 and 2: How to Kill a Black Swan Remy Brian
Page 3 and 4: www.journalofindexes.com Vol. 12 No
Page 6 and 7: FREE subscRiption oFFER! The Journa
Page 8 and 9: David Smith Publisher dsmith@fa-mag
Page 10 and 11: Editor’s Note Got Risk? Jim Wiand
Page 12 and 13: How To Kill A Black Swan Risk and a
Page 14 and 15: Figure 2 Comparison Of Asset Return
Page 16 and 17: Figure 5 Historical Real Returns Fo
Page 18 and 19: Figure 8 Subset Of A Multi-Asset Cl
Page 20 and 21: Benchmarking Policy Portfolios How
Page 22 and 23: investor has decided to benchmark 8
Page 24 and 25: An Interview With Susan Mangiero By
Page 26 and 27: How To Minimize Your Cost Of Tradin
Page 30 and 31: ETF Trading Volume Is Huge, Growing
Page 32 and 33: Figure 5 Hypothetical ETF Limit Ord
Page 34 and 35: Gastineau continued from page 31 th
Page 36 and 37: Portable alpha approaches—which e
Page 38 and 39: to write the book “Portable Alpha
Page 40 and 41: sitated more routine adjustment in
Page 42 and 43: Bogle’s Corner The Fiduciary Prin
Page 44 and 45: at the direct expense of the invest
Page 46 and 47: Talking Indexes Managing The Risks
Page 48 and 49: News CVC To Buy iShares … Or Mayb
Page 50 and 51: S&P Introduces Risk-Controlled Inde
Page 52 and 53: News New SPDR Offers Twist On Mortg
Page 54 and 55: Global Index Data Selected Major In
Page 56 and 57: Morningstar U.S. Style Overview: U.
Page 58 and 59: Exchange-Traded Funds Corner Larges
Page 60: “For a strong foundation in my cl

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