Trading tips for ETF investors grappling with market volatility

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Trading tips for ETF investors grappling with market volatility

Expert Perspective

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October 20, 2022

Even as the Standard & Poor's 500 Index fell briefly into bear-market territory during the second quarter of 2022, new assets continued to move into ETFs. Year-to-date net flows into equities and fixed income ETFs were at $292 billion as of June 30.1 With the U. S. Federal Reserve (FED) signaling that it is fully committed to fighting inflation, it's possible that volatility will continue to create challenges for investors this year.

For ETF-focused advisors keen on minimizing the transaction costs for their clients during times of market volatility, it's worth taking a closer look at how volatility can impact trading costs—particularly on days when big economic news is published during the trading session.

The volatility so far this year and the declines of asset prices have been quick, significant, and lasting. That is in large part because of the magnitude of inflationary pressures that have manifested in the macroeconomy over the last year and the Fed's response, which has been swift.

 

A tale of two Fed tightening cycles in the past seven years

A line chart traces changes in the federal funds rate between August 31, 2015, and August 31, 2002. It shows modest 25-basis-point rate hikes between 2015 and 2018, and relatively large rate hikes in 2022. It shows that the fed funds rate climbed 300 bps so far in 2022 and 225 bps in the nearly four years between 2015 and 2018.

Note: The chart above reflects the effects of Fed's latest policy decision on September 21, 2022, to raise the target federal funds rate by 0.75%, to a 3.00%–3.25% range through October 31, 2022, which is two days before the conclusion of the Fed's next policy meeting. 

Sources: The Federal Reserve Board and the Federal Reserve Bank of St. Louis FRED database from August 31, 2015, through September 21, 2022.

Close-up on Fed rate announcements

As the chart above shows, as of September 21, 2022, the Fed has raised the federal funds target rate by 300 basis points in about six months—a bigger change than occurred over more than three years of Fed rate hikes between 2015 and 2019. Again, the rapid increases in 2022 are behind much of the market volatility this year.

The other reason we're focusing on Fed rate announcements is that they always are released at 2 p.m. Eastern time—during the trading day. Other economic reports, such as the Institute for Supply Management's surveys on the manufacturing sector's health or The Conference Board's consumer confidence surveys, are also released during the trading session, monthly at 10 a.m. ET. Investors trading ETFs need to be mindful about how the timing of such economic announcements can affect trade executions.2

Volatility comes in different flavors

The Vanguard Global ETF Capital Markets team uses a proprietary tool, Vanguard Spread Analytics, to study spreads both in real time and historically. The tool provides precise insights on ETF spreads and basket spreads to help improve ETF product health, enhance pre-trade analysis, and provide more robust post-trade analysis. These insights can potentially give the Vanguard capital markets desk the ability to help clients optimize trading outcomes.

One of the clearest insights gleaned from the data is that more often than not, ETF spreads widen when economic news is released during the trading day. The second observation is that markets are much more on edge in the current post-COVID inflation-inflected environment than when the Fed announced gradual changes in interest rates between 2015 and 2019 in the context of considerably more modest increases in inflationary pressure.

The charts below show how trading spreads were affected by two Fed rate announcements a few years and worlds apart. They each show two sets of bid-ask spreads—one pair measuring those of Vanguard Consumer Staples ETF (VDC) and the wider pair measuring spreads on VDC's underlying basket of securities.

The first thing to notice is that the ETF spreads are tighter than the basket spreads most of the time. That's one of the advantages of ETFs—they have their own secondary-market liquidity, which makes trading them easier and less expensive than it is for their underlying basket of securities.

The two charts show that trading spreads widened in both instances. But the data also show that the widening this year was roughly twice that of 2019 and that the widening on a given day this year persisted, whereas spreads normalized quickly in 2019. In environments less volatile than this year's, we've observed market makers widening out bid and offers before a Fed announcement then quickly normalizing spreads within 15 minutes after it.

By comparison, the Vanguard Spread Analytics tool has shown us that this year, because of the unusually large Fed interest-rate increases, market makers have widened the spreads more than during less volatile periods and kept those wider spreads in play for longer periods of time—sometimes even until the end of trading sessions. Moreover, the spreads this year have been wider in the hours ahead of the Fed announcement than they were in 2019—another sign of greater volatility in general related to the Fed's aggressive inflation-fighting posture.

The key takeaway: Be hyperaware about trading on days when an important piece of economic news such as a Fed announcement will come out during the trading session. You may want to avoid making trades on such days, if you can.

The other factor to notice in the two charts is that at the beginning of each trading session, market makers have historically widened spreads for the first 15 to 30 minutes of the session before settling back to more normal ranges. So if you can, you may want to avoid trading ETFs in the first half hour of every session, as it can help minimize transaction costs.

 

Heightened volatility around Fed policy announcements in 2019 and 2022

Two line charts show trading spreads of Vanguard Consumer Staples ETF (VDC) for two entire trading sessions—May 19, 2019, and June 15, 2022—both days when the Federal Reserve announced changes to the federal funds rate. Both charts show all bid-ask spreads widening markedly at the moment the Fed news hits markets at 2 p.m. Eastern time. But the widening of trading spreads in 2022 is considerably greater than in 2019 and persists for a longer amount of time in 2022 than it did in 2019. Each chart shows two sets of bid-ask spreads—one set showing spreads on the ETF and the other showing spreads on the entire basket of individual securities contained in the ETF. In both charts, the ETF spreads are, at all times, narrower than the spreads on the basket of underlying securities, in a clear sign the ETF has its own liquidity, which manifests in tighter spreads and results in lower trading costs. Both also show spreads widening in the first 30 minutes of each trading session, and the first chart also shows a sudden spike at 10 a.m. ET when the Institute of Supply Management’s monthly survey on U.S. manufacturing was released.
Two line charts show trading spreads of Vanguard Consumer Staples ETF (VDC) for two entire trading sessions—May 19, 2019, and June 15, 2022—both days when the Federal Reserve announced changes to the federal funds rate. Both charts show all bid-ask spreads widening markedly at the moment the Fed news hits markets at 2 p.m. Eastern time. But the widening of trading spreads in 2022 is considerably greater than in 2019 and persists for a longer amount of time in 2022 than it did in 2019. Each chart shows two sets of bid-ask spreads—one set showing spreads on the ETF and the other showing spreads on the entire basket of individual securities contained in the ETF. In both charts, the ETF spreads are, at all times, narrower than the spreads on the basket of underlying securities, in a clear sign the ETF has its own liquidity, which manifests in tighter spreads and results in lower trading costs. Both also show spreads widening in the first 30 minutes of each trading session, and the first chart also shows a sudden spike at 10 a.m. ET when the Institute of Supply Management’s monthly survey on U.S. manufacturing was released.

Note: The pair of outermost lines on each chart represents bid-ask spreads on baskets of underlying stocks; the innermost lines represent bid-ask spreads on Vanguard Consumer Staples ETF.

Source: Vanguard Spread Analytics tool; May 19, 2019, and June 15, 2022, ETF bid/offer and basket bid/offer. Past performance is no guarantee of future results.

Double down on good trading practices

It's worth approaching trades with extra care given the current economic environment so that you can minimize transaction costs. Some basic factors to keep in mind:

  • Order type: Consider using a limit order or marketable limit order3 to protect yourself from unexpected price movements. For larger, "high touch" trades, you'll likely need to work with your custodian’s block trading desk to execute the order with greater discretion.
  • Trading during key events and economic announcements: As we showed in the earlier example of how markets behave around Fed announcements, placing trades leading up to and immediately following the release of economic news or policy decisions can expose those trades to additional volatility. If possible, you may want to avoid trading at those times to help clients achieve better outcomes. Also, avoid trading in the session's first 30 minutes and final 15–30 minutes.
  • Time of day: Opening/closing auctions can have imbalances that expose investors to heightened risk of trading ETFs at prices that differ from the value of their underlying securities.
  • If you must trade: Take measure of how the trade is being affected by any market volatility. Then adjust your approach and your expectations accordingly.

Contact your sales executive at Vanguard Financial Advisor Services™

To learn more trading tips, reach out to your custodian's block desk or contact your representative at Vanguard to connect with the ETF Capital Markets team. The team can provide insights and pre-trade guidance for your large trades to help avoid a poor ETF execution.

 

1 Morningstar, as of June 30, 2022.

2 Economic announcements that fall outside of market hours, such as the U.S. Department of Labor’s nonfarm payrolls report, which usually arrives on the first Friday of every month at 8:30 a.m. ET, are priced in before the market opens, hence our tight focus on intraday economic news, such as Fed rate announcements.

3 A marketable limit order is one that is placed for immediate execution. For a marketable buy limit order, the limit price is set at or above the ask price. For a marketable sell limit order, the limit price is set at or below the bid price.

 

Notes:

  • For more information about Vanguard funds or Vanguard ETFs, obtain a prospectus (or a 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 possible loss of principal. Diversification does not ensure a profit or protect against a loss.

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