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

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Figure 5 Hypothetical ETF Limit Order Book At The End Of The Trading Day Bids Offers 25.30 10,000 25.25 25.20 25.15 25.10 2,000 25.05 25.00 24.95 24.90 2,000 24.85 24.80 24.75 24.70 10,000 ate alongside this limit order book with buyers and sellers entering market orders of various sizes for execution at the close. If the balance of the MOC orders is to buy 4,000 shares of the ETF at the market-on-close and the limit order book matches the table, all the MOC orders will be filled at $25.30, unless a market maker or a last-minute customer order improves on the $25.30 offer. The lowest price at which an order to buy 4,000 shares can be filled is $25.30, and market rules require that all 4,000 shares trade at that price. Until the official trading close for ETFs was changed from 4:15 p.m. to 4:00 p.m., MOC orders for ETFs were not subject to the same rules as MOC orders on stocks. Now, all MOC orders are accepted until an exchange-specified cutoff time for such orders, usually 3:40 p.m. After that time, orders to trade at the market-on-close will be accepted only on the side of the market that will reduce any trade imbalance. Specifically, if the balance of market-on-close orders is to buy 4,000 shares of XYZ and the limit order book looks like Figure 5, additional MOC buy orders will not be accepted after 3:40 p.m. Market-on-close sell orders will be accepted to reduce the imbalance. Regular trades will interact with the limit order book until 4:00 p.m. These MOC rules work for very actively traded ETFs because active trading in index instruments attracts arbitrageurs. Market-on-close orders for less active ETFs often lead to trades far from NAV because the order book is sparse and because market makers tend to widen spreads at 4:00 pm. Less actively traded ETFs are not subject to continuous monitoring by arbitrage-motivated traders. In our numeric example of ETF market-on-close trading, the net asset value of the fund is $25.00. The midpoint between the bid and offer at 4:00 p.m. is also $25.00. Yet barring a last-minute MOC sell order or a new limit order to sell at least 2,000 shares at less than $25.30, market-onclose orders will be filled at $25.30, 1.2 percent above the net asset value. The ETF’s premium/discount calculation for the day will show the “market price” based on the bid and offer at 4:00 p.m. matching the net asset value at 4:00 p.m. Publication of a zero premium or discount based on 4:00 p.m. quotes relative to NAV encourages ETF investors who do not understand the transaction mechanism to use MOC orders incautiously. While the premium/discount information published for ETFs is calculated as the prospectus says it is, this calculation has led to unanticipated results for many investors. Even if some professional investors find market-on-close ETF executions useful at times, I can think of no reason why a typical investor should use an MOC order to trade ETFs. For actively traded ETFs, the intraday market in the last hour of trading operates well, and spreads are among the tightest of any time during the day. For less actively traded ETFs and for investors who want a more easily managed trading option, the NAV-based market—described at length in the next section—will usually deliver executions closer to and more consistent with net asset value than either an intraday or an MOC execution. The availability of NAV-based secondary market trading will assure that an investor can lock in a price related to a specific net asset value calculation. Investors can access trading liquidity available during the entire period that the NAV-based secondary market is open—a full-day trading session, at minimum. If defined contribution plans like 401(k)s and advisers accustomed to buying and selling mutual funds at net asset value use MOC orders for ETF transactions, the deviation of market-on-close executions from NAV may increase as these plans and advisers make greater use of ETFs, especially less actively traded ETFs. 7 Introducing NAV-Based Trading In ETFs As noted in the opening paragraph, one of the compelling advantages of most ETFs for long-term investors is that each shareholder 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. Net asset value-based trading in ETF shares preserves this protection from other investors’ fund share trading costs and enables investors to buy and sell ETF shares at a price related to—and no further than a predetermined distance from—net asset value. We will see that, in contrast to trading cost uncertainty in the intraday trading of ETF shares “just like a stock,” NAV-based trading makes it possible for investors to know and control their ETF transaction costs with minimal order monitoring. Entering an order to buy or sell ETF shares at or relative to the current day’s NAV is only superficially like entering a limit order to buy or sell shares in the traditional intraday ETF market. Buy and sell limit orders are entered and executed relative to a proxy of 100.00 for the per-share net asset value that will be calculated based on the value of the ETF’s portfolio at 4:00 p.m. A transaction at net asset value plus 1 cent per share would be recorded at 100.01. If the fund’s NAV for the day turns out to be $20 per share, the 100.01 would translate to a price of $20.01 because each .01 translates into $0.01 (1 cent) per share. (We omit $ signs on the proxies to avoid the implication that the transaction will occur near $100 per share; 100.00 is merely a reference point.) Most investors will want to check current bids and offers 30 July/August 2009
in the NAV-based market before entering orders in the conventional intraday market. The NAV-based quotation might be stated as “10,000 Bid at 99.99, 20,000 Offered at 100.01” reflecting buy orders totaling 10,000 shares at one penny below the end-of-day net asset value, and sell orders totaling 20,000 shares at one penny above the end-of-day net asset value for the ETF. It may be possible to buy ETF shares below the NAV or to sell them above the NAV, depending on the bids and offers available in the market over the course of the trading day. Even if a standing limit order to sell below NAV is not available in the marketplace when an investor checks the quote, an investor can place his own bid below net asset value at the market close, and that bid may be hit by an order to sell during the course of daily trading activity. Limit orders can be cancelled and new limit orders or market orders can transact with the limit order book until shortly after the close of traditional ETF trading. Transactions will occur throughout the day at or relative to NAV and the dollar execution price will be determined when the NAV is published shortly after 4:00 p.m. After-hours trading relative to the current day’s and the next day’s NAV will also be possible. The ability to create or redeem ETF shares each day should limit the size of any premium or discount on an ETF share as long as professional traders acting as market makers and arbitrageurs are reasonably attuned to the costs and opportunities of meeting demand for additional shares or redeeming existing shares of the ETF. Transactions in the NAV-based and traditional ETF markets are subject to similar fees and commissions. Information on these costs and trading choices will be available from your broker or adviser. Investors can compare differences in the spreads between contemporary bids and offers in the conventional intraday market and in the NAV-based market throughout the trading day. We have seen that locating the midpoint of the bid/ offer range relative to an intraday ETF value is not easy for the average investor in the traditional ETF market. Even if an investor has ready access to intraday NAV proxies based on contemporary bids and offers for an ETF’s portfolio securities, the portfolio value of many ETFs can change by much more than the typical bid/offer spread in just a few seconds. In conventional ETF trading, most investors cannot be confident that their execution will be as close to the contemporary NAV as they intend. The diagrams in Figure 6 compare limit orders in the NAV-based market (where an unchanged limit order may be appropriate for most or all of the trading day with little need for monitoring) with a sequence of limit orders in the intraday ETF market (where the appropriate level for a bid or offer can change more quickly than most investors can react). The right-hand side of Figure 6 illustrates the variability in the intraday value of the fund and highlights the limit order management problem that most investors face in the conventional ETF market as fund share values change. As noted, an investor’s order can trade only with bids and offers that are available in the market. Orders must be entered in the conventional ETF market to buy or sell at the market or at a specific dollar price, say $20.00 per share. Orders to buy or sell ETF shares relative to a contemporary or future ETF (portfolio) value are not accepted in the conventional ETF market. Orders to trade at or relative to the day’s official NAV are the essence of this new market that lets buyers and sellers express their bids and offers relative to net asset value. The transaction cost to buy or sell an ETF share in the NAVbased market is the sum of any fees and commissions plus (or minus) any difference between the execution price and the net asset value. With limit orders stated relative to NAV, an investor both knows and controls trading costs by this measure, whether the ETF is thinly or actively traded. Professional traders and market makers understand that continued on page 50 Figure 6 Entering Bids And Offers In NAV-Based And Intraday Markets Relative To End-Of-Day NAV Or A Series Of NAV Proxy Values NAV-Based ETF Market Conventional ETF Market A B C D E End-of-Day NAV Offer Bid NAV Proxy Offer Bid Price The Trading Day 15sec 15sec 15sec 15sec 15sec A bid or offer can be left in the NAV-based market all day without concern that the order will be picked off by a trader with better information. You will know and control your transaction cost relative to the closing net asset value of the shares if the order is executed. Time www.journalofindexes.com July/August 2009 31
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 30 and 31: ETF Trading Volume Is Huge, Growing
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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