• Most ETFs trade less actively and tend to be used for longer-term investing
• A few simple guidelines can help advisers efficiently transact in lower volume ETFs

One of the great things about ETFs is their versatility. ETFs are used by traders to speculate and hedge, by large asset managers to easily add or reduce market exposure, and by advisers and individuals as diversified investments for the long-term.

Unlike mutual funds, ETFs can be purchased any time during the trading day at prices very close to the net asset value of the fund, helped by a network of trading firms that keep the price of the fund in-line with its underlying securities. In contrast, mutual fund investors must purchase or sell shares only at the closing price and directly from the fund company. The “exchange-traded” feature of the ETF is clearly unique, but the benefit is not as clear for most investors.

Vanguard founder John Bogle, despite being a top issuer of ETFs, would argue this increased opportunity to transact only encourages more harmful short-term trading instead of long-term investing.[1] For active trading, hedging, and other time-sensitive activity, the increased trading frequency of ETFs is critical. But the number of ETFs that trade frequently enough to be used in this way are relatively few, which in our view, suggests that most ETFs are being used as substitutes for mutual funds for long-term investing.

As of August 24, 2018, there were 1,468 equity ETFs listed in the US with at least one share traded in the last 30 days. Trading activity is very concentrated in a small number of funds, with a large portion of the assets far less active. The top 20 funds by value traded totaled only 29% of the assets but constituted 67% of the average daily traded value. This means that 99% of equity ETFs (1,448) totaling a little over 70% of assets–$2.1 trillion—made up only 32% of the value traded.[2] We believe this suggests that an overwhelming majority of products are used as investing rather than trading vehicles.

The speculator using a very liquid ETF for a day-trade will have different needs than the adviser using low-cost funds to allocate for the long term on behalf of their clients. But both share a common market mechanism that is more advantageous for some participants and less so for others.

Trading Big and Small

Unlike with individual stocks, the trading of large blocks of ETFs is generally very efficient–as long as the fund is composed of liquid underlying securities. Since the price of the ETF is tethered to the value of the underlying stocks, a large block can easily be created (or redeemed) by an authorized participant (AP) directly with the fund, often with minimal impact to price.

With smaller orders, it can be more challenging to trade in ETFs outside of the top 50 or so by volume. The adviser must contend with trading spreads, volume, and timing of their trades, all of which involve some nuance to master.

From my experience as a former market maker, trading technology product manager, and exchange executive, I’ve seen a lot of different types of order flow. It may take some time to become truly proficient in trading, but luckily there are few simple guidelines that can help navigate the markets and obtain a good execution when trading smaller (below one creation/redemption unit) orders in lower volume ETFs.

1. Don’t trade right at the open. Many smaller investors place orders outside of market hours (the previous day or early in the morning) which are queued up for execution on the opening auction. Equity ETFs are priced based on the value of their holdings. If the underlying stocks have not opened yet, it is more difficult to arrive at a fair price for the ETF. Do yourself a favor and wait 10 or 15 minutes after the 9:30am open to place your order. This gives more time for the underlying stocks to open and for market makers to generally tighten their spreads.

2. Always use limit orders. Instead of leaving the price open by using a market order, use limit prices for all ETF orders. A limit order does not guarantee an execution so must be monitored to ensure the order ends up executing. Even if you want to pay the spread indicated on the screen, using a marketable limit (a price that buys at or above the offer or sells at or below the bid) is generally a good practice to avoid surprises.

3. Watch the spread and the iNAV. The current bid and offer should be spread close to the current iNAV (intraday net asset value), which is an indicative value for the fund based on the last sale of its underlying constituents published every 15 seconds during the trading day. Even for ETFs with low trading volume, the iNAV will update frequently as the underlying stocks fluctuate whereas the last sale in the ETF itself may be stale. For ETFs with underlying holdings that are not trading during US trading hours (foreign stocks) or have other asset classes represented in the fund (i.e. fixed income, futures, or commodities), the iNAV may not be as reliable as a pricing guide. But for domestic equity ETFs, the iNAV works well and can guide the placement of limit orders to help execute at a fair price.

4. Check the depth before diving in. Man, market makers are incentivized by the exchanges to not only quote a tight bid and offer most of the day, but also provide depth on both the best bid and offer as well as quotes below and above the inside. Unfortunately, most market data terminals only show a tiny fraction of this depth in a one-line quote. While most systems usually only display the largest quote from a single exchange as the size, there are typically quotes posted on multiple exchanges at the same price. What looks like 1,000 shares on the offer may actually be 10,000 shares if all the quotes are aggregated. Check the full order book (“Level 2” quotes”) if you have access or contact your broker, trading desk, or the issuer to better assess the true size available to trade at the current spread.

If you are patient, a limit placed in between the spread can be executed if the basket of underlying stocks moves the iNAV through your price as an arbitrage between the basket and the ETF will open up. For more immediate execution, compare the current bid/offer to the iNAV to determine whether paying the spread is reasonable.

The versatility of the ETF has been huge positive for investors, making it easier and cheaper to access the markets. But the one-sized-fits-all trading model isn’t necessarily optimized for the adviser or individual investor using ETFs as substitutes for mutual funds for long-term investing. There are number of great products in the market that are not geared towards active traders and have low average daily trading volumes. However, using these simple guidelines can help advisers and individuals trade almost any US equity ETF during the day, whether it trades 1,000 or 10 million shares a day. If the underlying securities are liquid and frequently updating prices, an efficient execution in the ETF is possible, whether it’s 500 little shares or a 50,000-share block.

[1] Norton, Leslie P. “Jack Bogle’s Battle.” Barron’s, 18 May 2018, www.barrons.com/articles/jack-bogles-battle-1526674385

[2] All figures sourced from Bloomberg as of August 24, 2018

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