Watch the news before trading ETFs

November 12, 2018

 
Chuck Thomas

Chuck Thomas
Head of U.S. Capital Markets

Adam DeSanctis

Adam DeSanctis
Capital Markets Analyst

Limiting transaction costs is essential when investing in ETFs. New data show that even routine macroeconomic news can provide an opportunity to revisit how incorporating a set of ETF trading best practices can help advisors reduce transaction costs.

We have seen how major macroeconomic events can cause stock market volatility and ETF bid-ask spreads to widen, increasing the costs to trade ETFs. But even routine news can cause spreads to widen—although briefly and not as significantly. Using real-time tick data, we can show the spreads of our ETFs as well as derive the spreads of the underlying securities. Reviewing these data allows us to demonstrate the value of Vanguard's ETF best practices.

Best execution, of course, comes by trading when bid-ask spreads are tightest. Before trading, it's important to be mindful of when ETF bid-ask spreads could be wider than average, and we can now see that includes what many would describe as routine market events. It also can include the market open and the market close.

A routine day

To illustrate this dynamic, let's look at the intraday bid-ask spreads of Vanguard Total Stock Market ETF (VTI) on August 1, a normal trading day that featured the release of a statement by the Federal Reserve's Federal Open Market Committee (FOMC) at the end of an uneventful two-day meeting.

VTI opened with a bid-ask spread of 6 basis points. That quickly fell to 5 basis points, then 3, then 2, before settling at 1 basis point after the first minute of trading.

For almost half the day, VTI traded with a skinny 1-basis-point spread. So a $100,000 trade that occurred right at 9:30 a.m., Eastern time, cost 5 basis points more, or about an additional $50. That 5-basis-point difference was a worst-case scenario on that day and was not indicative of typical trading.

Takeaway: Following the market open, single stock and ETF spreads tend to be wider than average, reflecting uncertainty related to price discovery.

Readers of this column will know we've said this before, but it bears repeating: Avoid trading at the open. It may be tempting to get orders placed after breakfast and move on to client meetings and other important tasks, but the execution could lead to indigestion later. It takes time for market participants, via trading activity, to settle on a clear price based on the news from the evening before. Because of this, bid-ask spreads for an ETF's underlying portfolio tend to widen in the first 30 to 60 minutes of the trading session. This uncertainty is reflected in the trading behavior of the ETF.

Intraday bid-ask spreads of Vanguard Total Stock Market ETF (VTI) and the underlying market
August 1, 2018

Intraday bid-ask spreads of Vanguard Total Stock Market ETF (VTI) and the underlying market

Source: Vanguard analysis, based on data from Bloomberg.

Note: The underlying market bid-ask spread is an estimate of how much it would cost to trade all the individual stocks in the VTI creation basket.

Note in the graphic above that VTI's spread is much tighter than the weighted average bid-ask spread of the underlying stocks tracked by VTI. Secondary-market trading volume is one of the main drivers of bid-ask spreads. VTI's relatively high secondary volume allows investors to typically trade the ETF at lower transaction costs than for the underlying stocks.

At 10 a.m. on August 1, the Institute for Supply Management (ISM) released its manufacturing report. July's Report On Business® came in slightly lower than expected, but not enough to move the markets significantly. Yet it was enough to widen VTI spreads on some trades briefly by as much as 1 to 2 basis points.

At 2 p.m., the FOMC announced, as expected, it was not raising its target for short-term interest rates. Markets largely took the news in stride. Still, spreads on VTI that had been trading close to 1 basis point suddenly widened to 2 to 3 basis points. Those spreads did not settle back down until eight minutes after the announcement.

Intraday bid-ask spread of VTI
August 1, 2018

Intraday bid-ask spread of VTI

Source: Vanguard analysis, based on data from Bloomberg.

To put this in perspective, for each $100,000 of VTI, a 3-basis-point spread would cost an investor about $30. Still, the first minute of trading after 2 p.m. averaged a spread of only 2 basis points, which shows that this reaction was brief.

Takeaway: Investors should avoid trading immediately after macroeconomic news since ETF spreads tend to widen then, reflecting underlying market uncertainty.

Wider spreads for smaller market slices

These are not atypical spread moves for VTI or any other ETF, for that matter. They are simply a function of the market and of market makers, who hedge their risk when they perceive any uncertainty.

VTI is a well-diversified fund, and its bid-ask spreads have historically been very tight. For ETFs that cover a smaller portion of the market, spreads can sometimes be wider. For example, Vanguard Small-Cap ETF (VB) had spreads ranging from 13 to 20 basis points during the first minute of trading on August 1. The ISM report made little or no difference to VB's spreads. The FOMC statement briefly caused spreads to widen as much as 9 basis points before falling back to roughly 3 to 4 basis points.

The fact that some ETFs can trade with spreads that are a little wider is a given. The point here is simply that timing matters.

Demonstrating your value

ETFs remain liquid during volatile periods, although wide market swings on days when the news is more dramatic can cause ETF prices to move sharply. These swings can lead to wider bid-ask spreads or larger premiums and discounts to net asset value, both of which can add to the costs of trading ETFs.

This effect remains, but is less pronounced, during less dramatic market events. So it can help to be aware of the news of the day, even routine news, when trading ETFs. This is especially true when trading large amounts, since the spread differences would be magnified. You can call your block desk, or our Capital Markets Team, to help with large block trades.

When trading ETFs for your clients, your goal, of course, is to execute the trade with as little cost as possible. That saves your clients money, which allows them to keep more of their investment returns, and is another way for you to demonstrate your value.

Best practices when trading ETFs

1. Use limit orders. Place a limit order to help protect the price of your order. Placing a market or stop order could result in a dislocation from the fair market value of the ETF in volatile trading environments.

2. Avoid trading around the open. Spreads are wider on average in the first 15 minutes of the trading day. There is potential for more volatility and less accurate price discovery at the start of the trading day and, therefore, market makers will tend to show wider bid-ask spreads until the market settles in.

3. For large trades, avoid trading near the close. There is a lot of liquidity at the end of the trading day, but there is the potential for ETFs to dislocate from a fair price if there is a large imbalance at the closing auction. Also, if a liquidity provider takes a trade too late in the day to create or redeem, it might charge for the extra risk it could carry overnight.

4. Avoid volatile markets. If the market is more volatile than normal, spreads are likely to be wider because of the extra risk a liquidity provider takes buying and selling shares. If you don't need to buy or sell during these times, you should look to avoid trading in roiled markets.

5. Use a block desk for large orders. If you are planning a trade that will outsize the market, you should consult with the block desk at your executing broker. Block desks are trained to find liquidity in a product at the best cost to investors and help them trade ETFs with the lowest impact on the price.

For more information on ETF trading best practices, reference our research paper "Best practices" for ETF trading: Seven rules of the road.1

If you are interested in speaking with someone on the U.S. ETF Capital Markets Team, please contact us at 800-997-2798.

1 Joel M. Dickson and James J. Rowley Jr., 2014. "Best practices" for ETF trading: Seven rules of the road. Valley Forge, Pa.: The Vanguard Group.

Download the complete Fall 2018 issue of ETF Perspectives

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Past performance is no guarantee of future returns.
  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

 

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