Below I review common myths and how one may determine best execution for ETFs. I believe that there are 5 key common myths that plague many investors.
The slides below also give a nice visual and can be used as a desk reference.
The first myth is volume – investors will look at the screen and see that an ETF has not traded very much that day and assume that this security is illiquid and difficult to trade. Unlike stocks ETF liquidity is driven off the liquidity of the underlying securities not ETF printed volume. Unlike regular equities ETFs can issue new shares and therefore offer additional liquidity as frequently as necessary. Authorized participants use the creation redemption process to facilitate trading and satisfy market demand.
The next myth is “The last traded price for the ETF is close to the price that I should expect to pay or receive for my trade.” The last traded price is, simply the last traded price. Each and every trade is independent and has its unique characteristics that should not affect any trade that follows. These independent factors include when the trade was made, the market levels at the time and most importantly trade instructions.
Another myth related to price is that the last price is also a good representation of the true value of the ETF. The last price does not give you the best indication of the fair value of an ETF. Investors should reference the ETF IIV levels (ticker.IV). These levels will provide investors with intraday NAV’s of the underlying basket.
Another myth is related to the size of the trade. For instance – I need a full creation block to get an AP to create and offer lower trading cost. Trades of all sizes should be receiving best execution. If the trade is relatively small, the quote depth offered by the specialist through printed bid/asks should in most cases be wide enough to handle orders of 10K and below. Larger orders do not have to be full creation/redemption block sizes. Market makers should facilitate trades of 10K and above.
Last common myth is “I should be able to access liquidity for my buy order but will not be able to access the same liquidity for my sell order. This statement is simply not true. AP’s and market makers have no preference for buys or sells. These counterparties profit on the spread and will hedge either side of the position.
Best execution can be determined by a number of factors – the fair value of the underlying basket, getting competitive bid/ask information and finally communicating your objective through your trade instructions.
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