There's more than one way to trade an ETF: Learn how to get the job done.
In “Understanding ETF Liquidity,” we discussed how ETFs are different from and similar to stocks in terms of their liquidity.
So when it comes to trading ETFs, it should be no surprise that there are both similarities and differences between how to trade ETFs and how you trade individual stocks.
The simplest type of ETF trade to enter with your broker is a market order. It can also be the most dangerous.
When you place a market order, you are telling your broker that you want to trade an ETF right now—at whatever price it takes to attract shares. If you’re trading a small number of shares—less than 100—you’ll probably get the best available bid or ask on the public markets.
But that’s no guarantee. There are a number of risks to this. First, if you’re trading in any size greater than a simple 100 share lot, the price you get for your trade may be much worse than the publicly available bid or offer. The “market” will decide where to price your outsized trade, and chances are, the “market” isn’t your friend.
Second, many ETFs trade with wide advertised spreads to begin with. Less liquid ETFs may show spreads of 10% or more—an absurd price that mostly reflects the fact that no one is paying attention. But if you’re putting a market order in, those will be the prices you get. (See “How Things Trade: Bid/Offer Spreads” for more information.)
The point is that transaction costs are difficult to control with market orders so investors looking to minimize transaction costs may prefer other types of trade orders. However, if guaranteed, split-second execution is important to your strategy (you want to buy very quickly) then the expediency advantage of market orders may outweight the risk of higher transaction costs.
One step better than a market order is a limit order. A limit order tells your broker the maximum price you’re willing to pay for an ETF or, if you’re selling, the minimum price you’ll take. It protects you from wildly bad executions, although it means your trade won’t happen if the market moves away from your order.
The request for quotes (RFQ) system—which is a variation of the request for proposal (RFP) system—falls into this category. The RFQ system is an electronic multidealer system where both buyers and sellers are identified before the trade.
It brings in multiple dealers into the trade; consequently, you are able to get the best execution price.
Limit orders can be very helpful in getting an execution between the spread. If a given ETF is advertised at £50.50 to buy and £49.50 to sell, and the iNAV of the ETF is at £50, chances are that a limit buy order placed closer to £50.10 will get executed and save you 80 basis points, if you’re patient.
A final order type available on many ETFs in Europe is the “NAV +/-” order. As the name suggests, entering a NAV +/- order allows you to purchase an ETF at its stated end-of-day NAV, plus or minus a stated spread. At-NAV trading eliminates some of the uncertainty that ETF investors face, by removing the possibility of premiums and discounts. (For more information, see “NAV And Fair Value”or “iNAV and Intraday Fair Value.”)
The drawback, of course, is that NAV orders are only executed once per day, at the end of the day, like mutual funds. Moreover, not all ETFs or brokers offer NAV trading, so you may have to pay a small premium over NAV to acquire the ETF in a timely manner.
Using Liquidity Providers
For investors placing large trades, one additional option exists: working with liquidity providers. Liquidity providers are large institutional market makers who exist (at least in part) to help investors buy and sell ETFs. Think of them as facilitators.
For the most part, liquidity providers don’t work with individual investors. But if you’re a financial advisor, contacting one for a large trade can be a smart idea. They use their reach, distribution and trading technology to evaluate the lowest-cost way to get a particular trade done, and can be an enormous help and cost saver.
If this route sounds like it might be for you, consider calling the issuer of your ETF and request to speak with the capital markets desk. If you’re moving a big trade, they’ll help you get it done at a fair price.