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There are over 1300 ETFs right now, with another 900 in registration. This explosion of alternatives is great for driving down fees and giving investors choices. However once we figure out what we want to buy, we often discover the fund we chose is lightly traded—perhaps only hundreds of shares are traded on any given day. With a lightly traded fund the bid/ask spread is usually significantly wider than the one cent spreads we are used to seeing with the big funds and stocks. The thumbnail below (click to enlarge) is from Fidelity Active Pro’s order book of Barclays’ VQT. The fund has almost $200 million in assets under management—but its order book is still ugly.
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Order Book for VQT
The best quoted bid/ask spread in the order book is $0.08, not great but only a 0.06% hit on the overall value of the trade. However, those quotes are only for 100 shares. For 200 shares the spread widens to $0.44, and for a 1000 shares the visible book widens to 125/129.54— a chilling $4.54 spread.
If someone was careless enough to enter a market order to sell 1000 shares the likely result would an average price of 126.86, 1.5% lower than the best bid price. Perhaps a market maker would step in to prevent this sort of carnage, but there are no guarantees.
Which brings us to rule #1: Always use limit orders unless the security you are trading has narrow spreads and deep liquidity
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However things are not nearly as grim as they seem. Unlike illiquid stocks, ETFs have built in processes to provide liquidity when needed. The process is called the share creation / redemption process, and it allows groups called Authorized Participants (APs) to routinely respond to the market’s demand/distain for ETFs shares in 50K+ share increments.
For example, if market forces are causing a ETF’s price to drift significantly up from the net asset value (NAV), then an AP can step in and make a profitable, essentially risk free arbitrage transaction that creates more shares. The AP (and the ETF) are very happy to create shares until the increased supply has driven the market price down close to the NAV value. The reverse situation, with the ETF price below the NAV is also profitable for the AP to correct by redeeming shares.
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This brings us to rule #2: Know what the NAV value of your ETF/ETN before you trade.
The NAV value is available on Yahoo Finance by adding a “^” to the beginning of the symbol, and a “-IV” to the end. For example the NAV symbol for VQT, is ^VQT-IV. On Bloomberg us add IV:IND to the end of the symbol: VQTIV:IND. See the thumbnail below, for an example of a NAV quote. You will probably won’t be able to buy or sell right at the NAV price, but you should be able to get close.
NAV for VQT
Knowing the NAV value will help you recognize if the market is out of balance. Normally the NAV will be close to the middle of the bid/ask spread—if not be especially careful.
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If your trade is going to be large (e.g., 10,000 or more shares) you should check with liquidity providers like Wolverine, Knight, or Wallachbeth to see if they can facilitate your trade. There is an excellent IndexUniverse webcast that includes some demos of how these firms can provide great quotes for even million share transactions on lightly traded ETFs.
If your trade is small, say 100 shares, then a limit order should be fine. If you want to score a few pennies on the spread you can try placing your order between the bid/ask price and see if it fills. If it doesn’t execute you can cancel your order and improve your offer until it does complete.
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For larger orders things get a little trickier. I’ve tried “all or nothing” limit orders without much success. What has worked for me is a limit order set within the bid/ask price, biased a few cents in the market maker’s favor. I typically see partial fills, usually in 100 share blocks, until the order is complete. You only pay your commission once, assuming the order completes within the trading day. Of course there are risks to this; the market might move, or liquidity might be exhausted, but compared to the risk of a lousy price these seem like good risks to take.
Full disclosure: Long VQT at time of writing.
