Tolga Dokumcu, Director of Sales Trading and Execution

Trade execution is just as important in exchange traded fund (ETF) investing as the selection of funds most likely to match the needs of advisers’ clients. The returns from an ETF may even be improved by decisions such as the time of day to trade it.

For example, consider an adviser planning to buy an ETF listed in Australia which tracks an international basket of shares. Factors for the adviser to monitor include the liquidity of the underlying shares, foreign exchange costs on any given day, any taxes and transactions costs, plus the underlying market maker’s profit.

Much of the difference between trading stocks and ETFs stems from the fact the latter do not have a fixed number of units. Units are instead created to meet demand and the underlying assets are sold when the ETF units are sold.

The process works like this: when an investor buys an ETF, a market maker buys the underlying basket of securities for that product. The market maker then gives that basket to the ETF issuer and in return receives the ETF units which it delivers back to the end investor.

It follows that one of the biggest factors impacting the bid/offer spread on any ETF can be the liquidity of its underlying basket of securities.

For ETFs which track the world’s biggest markets, like the S&P 500 index, there is generally plenty of liquidity. But the situation can differ for specialised ETFs – especially in relatively small markets like Australia.

In practical terms, all this has implications for advisers and their clients:

• The rule of thumb for domestic ETFs is to place an order after 10.20 am (AEST), thus avoiding the first 15 minutes of the trade when ETFs are less liquid, and spreads are wider. 
  
  The ASX has a staggered open from 10 am in five groups, with the final group opening at 10:09 am +/- 15 seconds. During this time, the market maker will be quoting prices with wide spreads as the full portfolio cannot be accurately valued until all securities are trading. 
   
• It’s important to evaluate an ETF’s underlying liquidity before deciding what trade size to place. If the screen doesn’t offer large sizes at competitive spreads, brokers like AUSIEX can contact market makers to facilitate its completion in the most cost-effective manner.
  
  It’s even possible (in certain circumstances) to place bulk orders. This allows advisers who may have 15-20 clients with the same ETF holding to trade those holdings together instead of separately at different prices . This will avoid driving the price away from your own order when entering or exiting a position and to ensure fair and equitable treatment for your clients.
  
  Likewise, advisers making large purchases of specialist international ETFs will benefit from good relationships with their stockbroker. Again, the broker’s relationships with both market makers and ETF issuers can provide extra insight into the optimal time to execute large transactions.
   
• If you’re trading US-based ETFs, it’s possible to get a sense of the likely trading direction when the Australian market opens by monitoring the main drivers of overnight trading or following Dow Jones Industrial Average futures. 
  
  By contrast, depending on market conditions, orders for Asia-based ETFs may be best traded when the underlying market is open.
   
• For both domestic and global ETFs, an alternative strategy is to look at the iNAV (indicative net asset value) for an ETF on the issuer’s website. The iNAV allows investors to track the indicative net asset value of an ETF unit throughout the trading day to help decide when to buy and sell. You cannot buy ETF units at the exact iNAV as the market maker will always place a spread to provide a return for their services. 
  
  The market maker’s profit and loss can potentially be small or significant, depending on how investors are executing. That's why it's important to factor this information into trade execution decisions.

Trading technology, market demand and investor demand all continue to shape the fast-evolving ETF market. Fortunately, the techniques for getting the optimal outcome from trade execution are available to financial advice groups and independent advisers alike.

To find out more about how to optimise your ETF trade execution, contact your Account Manager or a member of our Business Development team.