ETF trading best practices

Christopher Johnson, Managing Director, Head of ETF Capital Markets, discusses ETF trading best practices, including tips on deciphering premiums and discounts and the potential impact of changing Fed policies on the markets.

ETF trading best practices
When I talk to investors and advisors about ETF liquidity and how they might think about trading, I think of four basic components that really are part of good or best practice in ETF trading hygiene. The first one is really an awareness, making sure you have an awareness of what your trading infrastructure constraints might be and anything around human capital. So I’ll go back to that in a second. The second component that I think about is making sure that you have an objective for the trade. And then you’ve chosen a benchmark against which you can measure your trading objective. Thirdly, I would consider the liquidity profile of the specific ETF that you’re trading. So this is where as an investor you need to be doing a little bit of due diligence around things like how does the size of my trade relate to historical average daily volume traded in the product. What time of day is best to trade the product based on the underlying asset class. And if it trades very large you also need to take into consideration things like to what extent will the underlying asset class be able to absorb the trade that I’m doing. Lastly, I actually think about the three earlier components as context. And then you want to develop a trading strategy and you want to stick to it.

Deciphering premiums and discounts
So premiums and discounts can develop really for three primary reasons that are all very different. Number one is that there is an imbalance in the buying and selling activity of the ETF during the trading day which can push the prices in one direction or another and essentially get to where the price point on the … the market price of the ETF is straying from the underlying intrinsic value of the assets. The second reason it can happen is really just about stale data. So you have an instance where you can imagine an NAV is typically calculated at the end of the day. Or even if it’s an intraday NAV that’s being calculated, it may be based on stale prices of securities that have traded in some other time zone. For example, you can think about an ETF sitting in the U.S. that trades based on Japanese stocks. Those stocks have been closed for some, you know, 12 or 13 hours. So the NAV is stale. So it’s not a real premium or a discount. But it appears as such because the ETF market price strays from that NAV.
The third reason premium or a discount can develop within an ETF is really market structure or a product specific. These instances are pretty rare, but you can think back a few years ago when we had the Arab Spring, the Egypt market was closed for a number of weeks. During that time period there was an ETF in the U.S. that tracks that market. And you can imagine anything else that’s covering a frontier market at that time, you get a dislocation because we have stale prices or market structures, if something’s closed it can’t be priced in terms of NAV. But realistically the ETF itself was a great price discovery mechanism for that market. And it was probably the best indicator of where Egypt stood during that time period.

Fed unwinding and fixed income ETFs
In the current environment I think there’s quite a lot of concern within the advisor community about the fact that The Fed is about to embark on an unwinding of the balance sheet. I think this has people concerned. And when we’re in a rising interest rate environment, people are concerned about the impact on bonds and bond ETFs. And I think people often point to the Taper Tantrum of May of 2013 as an indicator of some sort of dislocation that may occur within the ETFs. I think realistically a couple of things. Number one, we’re in a very different environment. If you think back to the Taper Tantrum and the reason it occurred, we were in an environment of seriously accommodative Fed policy. You had five or six years of active stimulus in the market. The Fed was actually out there actively buying bonds. And when they came out at that point, Bernanke made the announcement about their intention to taper their buying program This is actually the removal of stimulus. So you had this kind of anxiety within the marketplace that caused yields to spike at the time. Today’s environment very different, right, we are not in a stimulus environment. We’re actually in a rising rate environment.
And what The Fed is actually proposing to do is to draw down its balance sheet, but not by selling the treasuries. What they’re looking to do obviously is to allow for some of these … for the bonds that they’re holding in the portfolio, as they mature to retire those bonds and not reinvest the full proceeds. This is expected to take years to occur. So in reality I think the likelihood of a similar situation of the Taper Tantrum is very, very unlikely.
So I would say to most advisors in this environment that really what they should be doing is focused on their long term strategic asset allocation plan and don’t veer from that in light of market noise and turbulence in the short term.

An ETF capital markets team can be your resource
I think for many advisors, the first point of contact with questions about how to trade the ETFs is often going to be an ETF capital markets team. Across the landscape really, most of the major issuers have a team that is dedicated to the trading issues and the liquidity around the ETFs that they sponsor. These teams tend to be staffed with people who have extensive background on the trading side, spent many years on the brokerage side and market making in ETFs. And they can help, and these teams tend to be very, very happy to take those direct calls from clients and have a discussion about how best to develop a strategy for trading.

Related Content

ETF Insights: 9 key questions to ask your ETF provider

ETF enthusiasm is on the rise

ETF Insights: Coming of age