Shining a light on opening auctions when trading ETFs

With the rising popularity of ETFs, trading volumes continue to set records year over year. As a result, those of us on the Capital Markets desk are having numerous conversations about ETF structure and trading dynamics. Our goal is to help as many clients as possible achieve trading success through the best possible execution.

One topic that keeps coming up is the trading of ETFs during opening and closing auctions. Some of you who are more accustomed to investing in traditional mutual funds may want to place trades over the weekend, after the market has closed, or first thing in the morning. While that timing may work for mutual funds, which strike a net asset value (NAV) only once a day, at 4 p.m., Eastern time, it’s not the best for ETFs. Trading ETFs in this manner results in the trade taking place during the opening auction, causing an unnecessary risk of trading the ETF at a larger premium or discount to its fair value, or NAV.

By shining a light on the imbalances that can occur in the opening auction, we hope to provide the keys to help ensure that clients have the best possible trading experience.

Understanding the mechanics of opening auctions can lead to better execution

When it comes to trading ETFs, the opening price can be dictated by the volume in the auction rather than the price of the underlying securities that make up the ETF. Any trade submitted after the prior trading session ends but before the next begins is queued up for the opening auction, which can expose the trade to additional risks. If there is a large buy imbalance or a large sell imbalance, the ETF price can swing to large premiums and discounts.

You don’t have to place a large order to receive a poor execution in the opening auction. If other market participants create an imbalance in the opening auction, even the individual who submits a single-share order will participate in the collective execution, which could be at a significant premium or discount to the ETF’s fair value.

While exchanges tend to have orderly ETF opening and closing auctions and extreme imbalances with significant price impacts are rare, it’s important to understand that the risk does exist, and pricing can be more volatile during ETF auctions without the creation/redemption mechanism. Remember that the creation/redemption mechanism helps ETFs remain close to fair value because new shares can be created or redeemed by liquidity providers who have clear insight into the value of the underlying securities in the fund.

What an orderly opening auction looks like

Here’s an example of an opening auction that operates in an orderly fashion. There are 10 investors attempting to buy varying share quantities of an ETF valued at $100 per share using a combination of market orders and limit orders. Simultaneously, there are 10 investors attempting to sell the same ETF. All 20 investors’ orders are eligible for the opening auction. This example demonstrates an orderly opening, with ETF buy orders perfectly matched with ETF sell orders.

The 24,000 ETF shares would execute at an official opening per-share price of $100, which is in line with the fair value of the fund. This happens because the 24,000 shares on the buy side are offset by the 24,000 shares on the sell side (market orders).  As a result, there is no imbalance in the opening auction and the exchange is able to execute all orders without an impact on price.

What happens when there is an imbalance in the opening auction

In this example, there are 10 investors attempting to buy varying share quantities of an ETF valued at $100 per share using a combination of market orders and limit orders. Simultaneously, there are 10 investors attempting to sell the same ETF. Again, all 20 investors’ orders are eligible for the opening auction. However, this example displays an opening imbalance that has surprising price ramifications for the ETF.

In this example, 54,600 shares would execute at an official opening price of $102.50—250 basis points above the ETF’s fair-value price of $100.

The exchange executes all market orders—buy and sell—that participate in the opening auction (with certain exceptions).¹ There are market sell orders for only 4,000 shares that could be used to offset the market buy orders for 54,600 shares, resulting in an opening imbalance of 50,600 shares.

The imbalance forces the exchange to execute limit orders on the sell side starting at the lowest price until it is able to execute all the market buy orders that are part of the opening auction. Therefore, a single investor trying to buy 50,000 shares of an ETF can cause all other participants in the opening auction to trade at a price above the ETF’s fair value.

ETF trading best practices

Given the risks of trading in the auctions, consider these best practices:

• Avoid trades (especially larger trades) during the opening and closing auctions if possible.
• If you decide to trade in the auctions, consider using a limit order or marketable limit order to avoid unexpected price movements.
• Be mindful about placing orders outside normal market hours for thinly traded ETFs since the opening prices can be significantly affected.

1 Auction collars and exchange halts are a few examples of market orders that may not receive execution in the opening auction.

Notes:

• For more information about Vanguard funds or Vanguard ETFs, obtain a prospectus (or summary prospectus, if available) or call 800-997-2798 to request one. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
• 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.
• All investing is subject to risk, including the possible loss of the money you invest.