Most Popular ArticlesSeptember 15, 2009
Effective trade execution
Now that we can determine whether an ETF is efficiently priced, we need to address the execution of trade orders. Always use limit orders. Sending a market order for even one of the most frequently traded ETFs will often result paying an unnecessarily high price or selling for too little relative to the ETF’s real value. Large liquid indexes and all of the products trading on exchanges that are linked to them have daily turnovers in the billions of dollars, so it is highly unlikely that one investor is going to move the IV of an ETF like RWL, even with an order of a few hundred million dollars.
Is it possible to receive poor execution on a market order, whether buying or selling? Absolutely. Some fiduciaries shy away from ETFs that don’t trade millions of shares on a daily basis because of a poor execution experience. Market orders will catch up with an investor eventually, even with high volume ETFs. Investors could be losing pennies on larger orders and not even realize it due to poor execution. Marketable limits when buying or selling are a necessity, and set the highest price an investor is willing to pay or the lowest price at which they will sell to get the order filled.
Large orders
Large investment advisors who trade exclusively using block orders and large institutional money managers will want to work with a trading desk or ETF liquidity provider directly when entering or exiting ETF positions. The guidelines I laid out earlier are still important, as investors should be aware of an ETF’s IV as well as the price they are willing to pay or take to get order filled in its entirety. Contact an ETF liquidity provider directly if you have the resources or call your trading desk. Specify the size and side of the order, and note any specific instructions. For instance, a large advisors might want to purchase 120,000 shares of an ETF, but in pieces because he had no strong view of how the market was going to perform from midday until the end of the session. You can ask your trading desk to “work the order the best way.” If an ETF tracks a highly liquid index, and an investor properly works through a trading desk and/or uses limit orders, he or she can effectively enter or exit positions and receive fair execution without moving the IV of the ETF.
The following example defies the ETF industry mantras of “Trading volume matters” and “Trading volume and liquidity are the same.”
Scenario
The RevenueShares Small Cap fund, RWJ, on average only traded 15,000 shares per day through May 1, 2009. Most investment advisors and portfolio managers would have dismissed RWJ as a potential investment due to the erroneous perception of low trading volume equaling low liquidity.
On May 1, the first block trade occurred at 11:30 AM ET with a bid of $18.84 for 1,000 shares and an ask of $19.00 for 1,000 shares. Most investors would turn and run the other way if they saw a 16 cent spread and only 1,000 shares on the inside bid/ask because the perceived illiquidity would present a barrier to effectively getting in or out of a position. However, a portfolio manager bought 50,000 shares at 18.90, which was in between the bid/ask spread. Keep in mind, 50,000 shares at the time was more than three times the average trading volume in the ETF!
For those who would expect the ETF’s price to immediately rise since a buyer is present in an “illiquid” market , this myth was also dispelled. The 50,000 share order, while large for RWJ, was a drop in a bucket in the context of the S&P 600 index, and did not cause a ripple in terms of price impact. Thus, the price of RWJ following the 50,000 share block order was not affected.
The portfolio manager bought another 50,000 shares at 12:22 PM with a bid of 18.90 for 100 shares and an ask of 18.93 for 1,000 shares. Think about that: 100 by 1,000 shares. Most institutional money managers wouldn’t touch RWJ if they saw this on their screen. The portfolio manager bought 50,000 shares through his trading desk AT 18.93. That’s correct - the execution took place on the ask without any adverse price impact.
A few hours later, at 3:18 PM, the portfolio manager wrapped up his buy order with a final 20,000 share block order with the market in RWJ looking like this: Bid $18.81 for 2,000 shares and Ask of $18.93 for 100 shares. Here, the 20,000 shares were executed at $18.91, again in between the visual bid/ask on the screen.
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