Executing at the best possible price is an important consideration for all investors and can have a substantial impact on an investor’s return over the long term
Generally, the higher volume and more liquid the ETF, the better the price execution. That being the case, investors should take particular care with how they place their trades with more thinly traded ETFs
Most commentary on the cost of trading securities suggests that the appropriate way to measure the cost of the bid/offer spread in a purchase or sale is to assume that your cost of trading will include half of the spread on the purchase and half of the spread on the sale. That is a reasonable rule of thumb when you are trading reasonable active ETFs in small size.
For actively traded benchmark index ETFs (where the spread during the last hour of trading will typically be a penny with large quantities available on both sides of the market), the location of the midpoint of the bid and offer will nearly always be close to the fair value of the ETF. Arbitrage forces and heavy trading will ensure this closeness.
However, it is not safe to assume that your execution price in an in a less actively traded ETF will be roughly halfway between the bid and offer in the intraday market. Most investor orders to buy or sell shares of an ETF on a given day will be on the same side of the market. If a fund has just been introduced, has enjoyed favorable commentary in the financial press, or is being actively purchased by advisors for their clients’ accounts, most investor orders will probably be on the buy side for days or weeks at a time. In contrast, if a particular market segment is out of favor or a fund has underperformed its peers, the predominance of investor orders for a fund will probably be on the sell side for long periods.
In other words, in the case of less actively traded ETFs where cross-market arbitrage forces do not provide much pricing discipline, the midpoint of the spread will reflect the supply/demand pressures of investor purchases and sales of the ETF shares much more than the prices in the underlying portfolio securities markets. If you are an ETF investor trying to make the same trade as other investors, you should expect your trading cost to include much more than half of the posted spread on most of your trades.
Last hour trading
If (1) you are trading no more than, say, 2,000 shares of one of the major benchmark index ETFs that trades more than 10 million shares a day, (2) the current price of the shares is consistent with your objectives and (3) the quote spread is close to the minimum of one cent per share, entering a market order at 3:30 P.M. Eastern Time, is generally safe. However, I would recommend comparing the size of your order to the quoted size on the other side of the market before you push the button to execute a market order.
If the thought of entering a market order in a volatile market environment is unsettling, you can enter a marketable limit order. A marketable limit order is an order to buy at the offer price or sell at the bid price currently posted in the market. As long as your order is not too large, it will usually be executed in full as long as the quote has not moved by the time your order reaches the market.
Given the rapid changes that are often characteristic of ETF bids and offers and the heavy volume characteristic of the last hour of trading, there is always a risk that your limit order will not be a marketable order when it reaches the market and, consequently, it will not be executed. You should compare the opportunity cost of failing to execute to the risk of a worse price with a market order. If an ETF trades less than, say, 100,000 shares a day, investor supply or demand may move the bid/asked range so that it does not even encompass the contemporary share underlying asset value. In other words, the bid may be above a contemporary NAV value calculation and the spread to the true intraday NAV for a purchaser of the shares may be greater than the posted bid/offer spread. Arbitrage forces are undependable when the potential for aggregate arbitrage profit is small due to lack of volume
Market on close orders
There is a great deal of misunderstanding about how market-on-close transactions in ETFs work. It’s important for investors to understand that market-on-close transactions in ETFs can prove costly. The principal problem is that a market-on-close execution in an ETF will not necessarily be priced at or even close to either (1) the midpoint of the indicative closing bid and offer published on the fund’s web site and in its prospectus or (2) the fund’s closing NAV. In the ETF market, market-on-close orders are integrated with limit orders. In essence that means, market-on-close buy orders are filled by matching with a limit orders. Depending on the limit order price, the market-on-close buyer could end up paying more than he or she might have with a market order just prior to the close.
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.