From the July 2013 issue of Research Magazine • Subscribe!

Getting Better Execution

Although commissions and expense ratios are easy to understand, financial advisors shouldn’t overlook another important measure of better ETF investing: savvy trade execution.

Most advisors understand the basics: The market price at which any ETF can be purchased is called the “ask” while the “bid” is the market price at which the same ETF can be sold. And the difference between these two prices is known as the “bid/ask spread.” What besides the bid/ask spread do you need to know about ETF orders? How can advisors coordinate their trades with trading hours of commodity and foreign exchanges to get better prices?

Research visited with Chris Hempstead, director of ETF execution services at WallachBeth Capital, to discuss best practices when it comes to placing and executing trading orders.

Do you think investors and advisors are getting smarter when it comes to ETF trade execution? What’s your top recommendation to them?

There has certainly been quite a bit of progress regarding ETF trade execution. Specifically, advisors and investors have been taught to use caution with market orders or to simply avoid them completely. The next step for investors will be to understand more about what defines an ETF’s liquidity. Far too often an ETF will be ignored simply because of low trading volume or low assets. The bid/ask spread of an ETF should be correlated to that of the underlying index. Lastly, understanding how the ETF tracks a particular index is critically important to understanding performance differentials. Some ETFs fully replicate an index and have very little if any tracking error, while others are optimized or use futures and can potentially have significantly greater tracking error.

How important is it for advisors using commodity and international ETPs to complete their trades when those markets are still open?

As a general rule, it is easier to source liquidity in an ETF when the markets of the underlying exposure are open. The simple reason is that a market maker can hedge his/her risk immediately with minimal time risk. If a market maker needs to wait 12 hours to hedge, you should expect a charge for that time risk. There are some exceptions to this general rule, however. ETFs with “super” liquidity will oftentimes trade fluidly regardless whether the underlying markets are open or closed. Names like GLD and EEM come to mind. With so many people using these products to express their views in these asset classes, liquidity in the underlying markets becomes less important.

The reputation of limit orders was badly maligned after the “flash crash” in 2010. Are these types of ETF orders still suitable?

Limit orders are fine. Stop orders, however, create some frustration for investors who thought having them would protect their investments. The election of these orders during the flash crash caused them some pain. While stop orders are still a valid order type, we encourage people to use extreme patience when executing orders during times of extreme volatility. Unless you know how a stop order works, I would advise you avoid them. Remember that there are stop orders (which turn into market orders when elected—be careful) and there are stop-limit orders (which turn into limit orders when elected —is your limit price relevant?). During the flash crash, most stop and stop-limit orders were elected and executed at levels the investors would have preferred to avoid.

What type of trading orders do you think advisors should be wary of and why?

There is a seemingly endless list of order types or algos [algorithms] available to advisors. Most, however, use only a handful. As stated earlier, be very careful when using market orders as posted liquidity is not always sufficient to fill your order. Also, when using VWAP [volume weighted average price] or POV [percentage of volume] algorithms, you need be aware of what your order’s participation will be for the duration of the order. For example, just because are targeting VWAP does not mean you are trading at optimal levels. If your order represents 50% of the volume over that period, expect to see significant price impact—something we continually seek to avoid.

Let’s suppose I need to make a $10 million trade in an ETF, how would a firm like WallachBeth help?

WallachBeth specializes in ETF execution and, more specifically, block execution. We first identify when the client needs to be completed with the order. With that we can determine the most efficient course of execution. We offer access to our deep network of ETF liquidity providers and market makers. We also give clients access to targeted real-time INAV pricing using the creation and redemption mechanism. Lastly, we have a suite of electronic execution routes that allow us to keep costs at a bare minimum. Using one or more of these avenues of execution allows us to get you the ETF exposure you want with the least amount of premium/discount to the index level. Minimizing the premiums and discounts on your execution is extremely important when seeking to avoid tracking error to the index. We believe we have the most efficient ETF execution model on Wall Street.

How do you think the services of market markers have evolved with the evolution away from floor trading to electronic trading?

Market Makers have evolved to “off-floor” trading remarkably fast and, in the process, helped make the markets more efficient. Unlike floor trading, market makers no longer know where “other” competitors are priced. They use sophisticated algorithms, pricing models, risk models and market access tools to make electronic bids and offers in ETFs. Because of the high level of competition and higher level of sophistication, they are often able to make bids and offers on ETFs with spreads of only a few basis points. Their expertise and volume in trading oftentimes affords them a lower cost than most advisors can obtain on their own. Despite the fact that some ETFs are “free” to trade, market makers have premium and discount built into their pricing models which gives them a chance to make a slight arbitrage profit on those trades.

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