Best Practices in ETF Trading: Check Your Watch

This is generally among the first comments we hear from ETF trading desks regarding “Best Practices” in trade execution. The common assumption is that if the US markets are open, and thus US-listed ETFs are trading, it is open season for transacting business in those funds. While you will in fact find a market on US-listed ETFs at any point between 9:30am-4pm ET, and thus market orders will gladly be accepted, those seeking the highest levels of liquidity and trade execution are generally advised to think a little further about what they are buying and how the time of day might impact trading.

For instance, we generally recommend avoiding any ETF trading in the first 5 minutes of the session (9:30 – 9:35am ET), particularly on US equity-based funds. The reason is quite simply that for an ETF to begin trading at, or near, the value of its parts (i.e. indicative value), we must first know the value of those parts. If we take into consideration an ETF tracking the S&P Mid Cap 400 Index, we know that it is simply a weighted portfolio of 400 securities. If 200 of the 400 securities have traded right around the open, the “value” of the other 200 is still yet to be determined by the market and thus the spread on that ETF will reflect the lack of information in the market. You can place a market order at 9:30 am to purchase the iShares S&P MidCap 400 Index Fund [IJH], it will be accepted and it will likely be filled. However, understand that the liquidity providers themselves can’t accurately guess the value of the S&P 400 itself when many of the stocks have not been traded. Price discovery is important, and until most of the largest weightings of an ETF have been priced, the spreads will generally be relatively wide and the executions less ideal.

 

 

By the same token we are often told by trading desks that best executions will be achieved when orders are placed (or awakened) when the majority of a fund’s underlying holdings are actively trading. For European Equity ETFs, for instance, we are recommended to transact such business early in the US trading day because London and other major European exchanges are still open. At that point in the day a market maker needn’t guess what the ETF components are worth, as they are still actively trading overseas. Emerging Market funds, in particular, will tend to include many securities that simply aren’t easily replicated or hedged by liquidity providers at times when the local markets are closed and the market will naturally reflect that with wider spreads.

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