Institutional investors buy and sell sizable blocks of exchange-traded funds on a daily basis. Trading commissions must be contained, but a more insidious -- and potentially much larger cost -- is market impact, or how much an order adversely moves the execution price.
For example, if the midpoint ‘arrival’ price between the posted bid and ask for a given ETF is $10, and a buy order is executed at an average price of $10.02, the market impact is 20 basis points. Given that trades may be in the millions or tens of millions of dollars, implicit market-impact costs can add up; for an ETF manager, moving the market even a little too much can mean the difference between outperforming and underperforming the benchmark.
“Market impact has a more negative impact on the performance of your trade, which follows through to the performance of your portfolio,” said Michael Baradas, product manager for cross-asset strategies and ETF solutions at Bloomberg Tradebook. “You can control your market impact if you're sourcing liquidity the right way, whether through algorithms, or through liquidity providers like market makers and block trading.”
Market impact can be a concern for traders in all asset classes. In the core-portfolio asset classes of fixed income and equities, corporate bonds and small-cap stocks are especially vexing for anyone looking to take on or unload a big position without shaking up the market. The most liquid ETFs -- just like on-the-run U.S. Treasuries or Apple stock -- are well-insulated from market impact, but anything below the top tier is susceptible to unwanted price movement.
“The magnitude of market impact will depend on the ETF and underlying securities in question, as well as how the investor executes their trade,” said Ben Johnson, director of global ETF research at Morningstar. “An investor could place a large market order for a highly liquid ETF offering exposure to an uber-liquid asset class -- like the SPDR S&P 500 ETF (SPY) -- and likely have little, if any, market impact. In the case of smaller, less liquid ETFs tracking relatively illiquid underlying securities, the odds of a large-sized trade (generally anything amounting to more than 10% of the ETF’s average daily volume) having an impact on the fund’s price are far greater.”
Added Johnson, “institutional investors should employ the help of ETF providers’ capital markets desks as well as their preferred partners within the market-making community to ensure that their trading activity doesn’t cause an ETF’s price to move away from them.”
The average daily volume of an ETF can offer some initial indication of liquidity, but a much more valuable gauge is order size as a percentage of ADV, Baradas noted. “If an ETF is trading 1 million shares per day, people would perceive that to be a liquid ETF,” he said. “But if you're trying to execute 500,000 shares, that order would have a big impact on the price. It would not have an impact on SPY, which trades more than 100,000,000 shares per day.”
Implicit market impact costs can make up two-thirds of total transaction costs, or double the explicit costs, Baradas said, citing Elkins/McSherry research. As such, Bloomberg Tradebook research has shown that ETF traders should consider block-trading strategies if a given order represents even just 1% of daily average trading volume.
Advances in post-trade processes are also helping. “Institutional traders are experienced in Transaction Cost Analysis for equities, and financial advisors are adopting these TCA tools,” Baradas said. “With TCA, ETF traders are able to measure the quality of their executions across their brokers, algorithms, and electronically traded blocks.”
Featured image by T/Dollar Photo Club