There's more to ETF investing than selecting funds: don't forget about the execution strategy

In the rapidly expanding ETF market, the quoted management fee isn’t the only price you can pay. Financial advisers and family offices can improve the overall returns by following a few simple steps.

The rise in popularity and rapid expansion of the ETF market in recent years means simply picking the investment that suits you or your clients best is no longer the only choice. Adopting the right execution strategy can potentially also add value.

Not unlike buying individual equities on the stock market, for most investors, returns from ETFs may be improved by such things as choosing the right time to execute your transaction based on the liquidity in the market on a given day and even the time of day.

According to ASX data for September, the average daily volume for Exchange Traded Products is currently running at over 28 million units, and the average daily value of trading is just over $434 million). The compound annual growth rate (CAGR) for the past 10 years has been 25.8%.

In this fast growing and sizeable market, the multiple layers of costs and charges underlying the on-screen bid/offer spread is opening opportunities for a savvy investor to benefit from tweaking their execution practices when buying and selling ETFs.

ETF and stock trading is fundamentally different 

Viktor Östebo, Head of Institutional Trading APAC for Flow Traders, a leading global market maker in ETFs, notes that a key feature of ETF units is that they are not fixed but rather are created to meet demand and these underlying assets are then sold when the ETF units are sold.

“What happens when an investor buys an ETF, we buy the underlying basket of that ETF. We give that basket to the ETF issuer, and they in turn, give us the ETF units which we deliver back to the end investor,” Östebo told an AUSIEX webinar on unravelling the mystery of ETFs last month.

“The main and biggest factor impacting the bid/offer spread on any given ETF is the liquidity of the underlying basket of securities,” he said.

Consider where an investor is choosing to buy an ETF listed on the ASX which aims to track an international basket of shares. There are factors like the availability to purchase the underlying shares, the foreign exchange costs on any given day, any taxes and transactions costs due and, of course, the underling market maker’s profit.

The market maker profit and loss can potentially be small or significant, depending on how investors are executing. That's why it's important to factor this in when you're determining how to execute.

Liquidity is key

Fortunately for ETFs which track big markets, like the S&P 500 index, there is a lot of liquidity available around the world throughout the day. But with more specialised ETFs, the situation can be different.

In Australia, for less traded ETFs, it’s key to evaluate the underlying liquidity before deciding what trade size is suitable. If the screen doesn’t offer large sizes at competitive spreads, a high touch desk can help ask market makers for quotes in full side on demand. “This is the way large institutions trade blocks of ETFs, reaching out to a price maker panel, more like bond trading than stock trading. More efficient and cheap than trying desperately to get filled on-exchange.” Says Östebo.  

Of those ETFs listed on the ASX, the top 100 account for nearly 90% of assets under management (AUM). There are only about 20 ETFs that have more than $1 billion in AUM.

Mr Östebo suggests that when considering large purchases of specialist international ETFs, it helps if financial advisers have good relationships with their stockbroker, where the broker’s contacts with market makers and issuers of the ETF’s can help add some insight into when to execute large transactions.

Simple steps can help

There are other, more fundamental steps available to any investor in ETFs.

“Remember the opening bell is not the best of time to trade in ETFs as prices can be very volatile. Leaving your trades to the end of the day can also make them more difficult and expensive,” Mr Östebo said.

“Every day you have investors buying and selling on the close (of the market), where they’re actually paying or receiving a number of basis points away from what the fund should have been worth”.

“Where you have very extreme markets, this deviation can be extreme”. The issue is magnified for little-traded ETFs with lower ADV, he added.

“So, the main message is, if you want to trade near the close of the market, then place your order taking into account the NAV (net asset value) of the ETF”.

New technology, greater popularity and different investor behaviours are all having an impact on the ETF market. The techniques for dealing with them are available to stockbrokers, smaller institutions, financial advice groups, family offices, not just the larger institutions and banks.