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

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ETF Trading Volume Is Huge, Growing And Highly Concentrated The growth of trading volume in the most actively traded ETFs has been nothing short of phenomenal, as Figure 4 shows. ETFs now account for more than 20 percent of U.S. equity trading volume by shares, typically more than 2 billion shares per day; weighted by dollar volume, the number is significantly higher, and has been reported as high as 35 to 40 percent on certain days. Most of the increase in ETF volume has been in the most actively traded funds. Typically, half of the most active “stocks” each day are ETFs. The most actively traded funds are often not the most attractive investments, however. In any event, you do not necessarily have to pay a wide spread to trade a less active ETF. Beginning with some useful “rules of thumb” for intraday ETF trading, let’s look at how ETF investors can reduce their transaction costs, particularly on less actively traded ETFs. How To Trade ETFs Efficiently If (1) you are trading one of the major benchmark index ETFs that trades more than 10 million shares a day; (2) the current price of the shares is consistent with your objectives; and (3) the quote spread is close to the minimum of $0.01 per share, entering a market order is generally a safe choice. However, you may want to compare the size of your order with the quoted size on the other side of the market before you push the button to execute a market order. If the thought of entering a market order in a volatile market environment is unsettling, you can enter a marketable limit order; that is, an order to buy at the offer price or sell at the bid price currently posted in the market. This order will usually be executed in full as long as the quote has not moved away from the limit on your order by the time your order reaches the market. Given the rapid changes that are often characteristic of ETF bids and offers and the heavy volume characteristic of the last hour of trading, there is always a risk that your limit order will not be a marketable order when it reaches the market and, consequently, it will not be executed. You should compare the opportunity cost of failing to execute to the possibility of a worse price with a market order. If an ETF trades less than a million shares per day, take a close look at the bid/offer spread, at the size of the contemporary bid and offer, and at recent changes in the bid and offer; then consider a marketable limit order—or read on for more analysis and more options. Most commentary on the cost of trading securities suggests that the appropriate way to measure the cost of the bid/offer spread in a purchase or sale is to assume that your cost of trading will include half of the spread on the purchase and half of the spread on the sale. That is a reasonable rule of thumb when you are trading common stocks in small size. However, it is not safe to assume that an inactively traded ETF’s current value is between the bid and offer in the intraday market. Most investor orders to buy or sell shares of an ETF on a given day will be on the same side of the market. If a fund has just been introduced, has enjoyed favorable commentary in the financial press or is being actively purchased by advisers for their clients’ accounts, most investor orders will probably be on the buy side for days or weeks at a time. In contrast, if a particular market segment is out of favor or a fund has underperformed its peers, the predominance of investor orders for a fund will probably be on the sell side for long periods. For very actively traded benchmark index ETFs (where the spread during the last hour of trading will typically be a penny, with large quantities available on both sides of the market), the location of the midpoint of the bid and offer will nearly always be close to the fair value of the ETF. Arbitrage forces and heavy trading will ensure their closeness. In the case of less actively traded ETFs where cross-market arbitrage forces do not provide much pricing discipline, the midpoint of the spread will reflect the supply/demand pressures of investor purchases and sales of the ETF shares much more than the prices in the underlying portfolio securities markets. If you are an ETF investor trying to make the same trade as other investors, you should expect to pay more than half of the posted spread on most of your trades in less actively traded ETFs. If an ETF trades less than 100,000 shares a day, investor supply or demand may move the bid/ask range so that it does not even encompass the contemporary share value. In other words, the bid may be above a contemporary NAV calculation, and the spread to the NAV for a purchaser of the shares may be greater than the posted bid/offer spread indicates. Arbitrage forces are undependable when the potential for aggregate arbitrage profit is small due to lack of volume. If you are interested in an ETF that trades fewer than 500,000 shares a day, don’t consider anything other than marketable limit orders when you are trading in the intraday ETF marketplace. If your order is larger than the number of shares quoted at your limit, expect to spend some time working the order—at best. If you are an adviser trading ETFs for a number of accounts, your broker may give you access to an algorithmic trading model that manages bids and offers relative to changes in the bids and offers for the securities in an ETF’s portfolio, much like a market maker would use. 5 Even better, your broker may arrange a dialogue with a market maker in the ETF’s shares. Working with a market maker on a large transaction is usually a very good idea. The market maker can trade at lower risk if he is filling an order rather than guessing what an anonymous bid or offer might mean. The probability of repeat business with you may also favorably affect the terms of a trade. After we take a close look at risks and costs of market-onclose (MOC) orders in ETFs, we will examine a new kind of trading in which orders can be entered for execution at or relative to the closing net asset value of the ETF. This new trading method will be particularly useful to ETF investors who want a good execution without spending a lot of time on order management and who have had unfavorable experiences with the intraday ETF market or with MOC orders for ETFs. This new trading method is important because ETF trading volume is increasingly concentrated in the most actively traded ETFs, while the most attractive investments are often in the less actively traded ETFs with wider bid/ ask spreads. A trading mechanism that narrows spreads and reduces total trading costs on less actively traded ETFs can change the ETF landscape in many important ways. 28 July/August 2009
Figure 3 Consolidated ETF Trading Volume In 15-Minute Increments, Week Of February 23–27, 2009 250,000,000 200,000,000 150,000,000 100,000,000 50,000,000 0 09:00-15 09:15-30 09:30-45 09:45-00 10:00-15 10:15-30 10:30-45 10:45-00 11:00-15 11:15-30 11:30-45 11:45-00 12:00-15 12:15-30 12:30-45 12:45-00 13:00-15 13:15-30 13:30-45 13:45-00 14:00-15 14:15-30 14:30-45 14:45-00 15:00-15 15:15-30 15:30-45 15:45-00 16:00-15 16:15-30 16:30-45 16:45-00 Source: NASDAQ OMX Figure 4 Average U.S. Daily Regular Session Share Volume Date ETFs Stocks Total Equities ETF % of Total Stocks % of Total 2009 to Feb 27 2,087,097,954 8,069,538,101 10,156,636,054 20.5% 79.5% 2008 1,531,157,474 7,298,488,173 8,829,645,646 17.3% 82.7% 2007 685,797,955 5,386,666,216 6,072,464,171 11.3% 88.7% Source: NASDAQ OMX Market-On-Close Transactions In ETFs Can Be Surprisingly Costly There is a great deal of misunderstanding about how MOC transactions in ETFs work. This section probably contains a great deal more information on these transactions than most investors will want, but any investor who considers using ETF MOC orders will find a careful reading of this material worthwhile. The principal message of this section is that a MOC execution in an ETF will not necessarily be priced at or even very close to the midpoint of the indicative bid and offer published on the fund’s Web site and in its prospectus. Reported ETF Premium And Discount Pricing As a prelude to an examination of MOC orders, it is important to understand what the information on premiums and discounts published in fund prospectuses and on fund Web sites means. ETF issuers collect information on ETF share bids and offers on the listing exchange market each day at 4:00 p.m. and compare the midpoint of these quotes with that day’s NAV calculation for the ETF. Premium and discount tables or graphs reflecting these comparisons are published in ETF prospectuses and annual reports. They give investors and the SEC inappropriate comfort that end-of-day ETF transactions occur very close to NAV. Market makers in even the most thinly traded ETFs understand that the midpoint of their daily 4:00 p.m. quote will be preserved in prospectuses and on ETF Web sites for years. Market makers have a stake in drawing traders to the ETFs they trade. Consequently, they monitor their real-time bid/offer NAV calculations very closely as 4:00 p.m. approaches. Even if they have to widen their spread for a few seconds, they will work to get the midpoint of their bid and offer as close to the expected 4:00 p.m. NAV 6 as possible. Their 4:00 p.m. quote is the most widely scrutinized and least useful bid/offer of the day. Publication of premium and discount information based on 4:00 p.m. ETF share quotes has led to overuse of MOC orders, especially for some ETFs that are thinly traded. Most investors do not realize that MOC transactions in ETFs are not reflected in most ETF-reported premiums or discounts in any way. Nonetheless, MOC orders are often used by individuals and defined contribution retirement plan investors who are accustomed to mutual fund trades at net asset value and to MOC orders on stocks. MOC Orders For Most ETFs Are Not Likely To Be Executed At Or Even Near NAV ETF market-on-close orders often result in executions at a much greater distance from the fund’s end-of-day NAV than the reported premium and discount data leads investors to expect. Market-on-close orders both in stocks and ETFs are integrated with the limit order books for these securities. The hypothetical schedule of bids and offers (limit orders) for an ETF at the end of the trading day displayed in Figure 5 will help illustrate how this integration works. In this limit order book, the best bid is for 2,000 shares at $24.90, and the best offer is at $25.10 for 2,000 shares. The MOC book will oper- www.journalofindexes.com July/August 2009 29
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 28 and 29: Figure 2 Offer NAV Proxy Bid Using
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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