An ETF Pricing Puzzle

On Monday I looked at the relationship between an ETF’s daily trading volume and its liquidity. Unlike an individual stock, an infrequently traded ETF should not necessarily have a wide bid-ask spread. But low volume can cause some confusion for investors, and I’d like to share an example.

For a while now I’ve noticed that the Horizons S&P 500 (HXS) doesn’t always move in concert with its index. On Tuesday morning the S&P 500 was up about 0.5%, but my brokerage was showing HXS down about the same amount. Moreover, the quote said the last order was filled at $12.43, while the bid price was $12.46 and the ask was $12.48. That didn’t seem to make sense: the last price should be between the bid and ask, not several cents lower or higher.

I called Horizons to ask what was going on and got a helpful response from Jaime Purvis, Executive Vice-President, National Accounts. But first let’s review how ETFs are priced, and how this differs from mutual funds and individual stocks.

NAV versus market price

With a mutual fund, the manager determines the net asset value (NAV) per share once a day after the market closes. If you place an order during the day, it will be filled that afternoon, and you will always get the NAV price, regardless of whether you’re buying or selling. There’s no bid-ask spread, which is an often overlooked benefit of mutual funds.

Since ETFs trade throughout the day, their net asset value must be constantly updated while the market is open. Market makers post bid and ask prices to reflect that NAV, with a small spread that represents their commission. If the NAV is $20 per share, for example, the bid price might be $19.99 and the ask price $20.01. The most liquid ETFs have spreads of just a penny.

Contrast this with an individual stock, where there is no difference between NAV and market price. “The value of a stock is determined purely by its trading price, which is de facto its market value,” Purvis explains. “While this is a simple concept, it can be jarring for investors used to buying stocks, and for advisors who are used to buying mutual funds.”

Unsung heroes of arbitrage

Occasionally an ETF’s market price drifts away from the NAV, but this doesn’t usually last long, because arbitrageurs don’t allow it to. Say an ETF holding a basket of 50 stocks has a net asset value of $20 per share, but its ask price is just $19.75. An arbitrageur could buy units of the ETF and simultaneously sell its 50 underlying stocks to net a risk-free profit.

We’re accustomed to thinking of high-frequency traders (HFTs) as evildoers, but Purvis says they perform a useful role. “This is actually one of the unsung benefits of HFTs: they ensure fair bid-ask spreads on ETFs for individual investors. In doing so, they take the profit from arbitrage opportunities.”

So the ETF pricing mechanism is fair, regardless of trading volume. But infrequently traded ETFs can be puzzling for investors, as my experience with HXS shows. When I saw the fund apparently down 0.5% on a day when the S&P 500 was up, I wondered whether I could do a little arbitrage myself, picking up the ETF for what seemed like a 1% discount at $12.43. Just for fun I threw in a market order for a couple of shares—and it was promptly filled at $12.48. So much for my discount.

The price is right

The reason turned out to be simple: HXS has low trading volume and mine was the first order of the day. The price of the last trade ($12.43) was out of whack because it had been filled the day before. As soon as I placed my order, the market makers went to work and I got a price that was right around the NAV.

The lesson is that you should ignore the price of the last trade and look only at the bid-ask spread. “If it looks like you can get the ETF at a discount, or sell at a premium compared to its last price, think again,” Purvis says. “It’s just that investors are hardwired to look at the last price of a stock to determine the value of the security. This is not applicable to ETFs.”

Purvis has an important tip for anyone trading ETFs, whatever their daily volume: “Always use limit orders. Always, always, always. No exceptions. Market dislocations can happen from time to time—like the Flash Crash of 2010—so protect yourself by putting in the price you want to pay. If it’s reasonable, it will get filled. Don’t be afraid to move the limit order if the underlying securities move substantially.”

On Tuesday, had I placed a limit order to buy HXS at $12.43, it would have not have been filled, because it was well below the fund’s net asset value. I should have placed a limit order right at the ask price, perhaps a penny higher. That would have eliminated the surprise of having my order filled at a price five cents higher than the last guy’s.

Horizons offers some other ETF trading tips here.

36 Responses to An ETF Pricing Puzzle

  1. Philippe V. September 13, 2012 at 10:15 am #

    These posts on liquidity and volume are quite interesting. Last year I bought Claymore’s global real estate stock (CGR) and came across most of the issues you mentioned. At least now I have a reference and explanations if I go out of my core asset classes again.

    One aspect about limit orders I wanted to touch on. The US markets usually have limit orders with an all or nothing option. This places a limit on price AND only fills if all the shares can be bought. On the Canadian market, the limit order can not be placed with an all or nothing option.

    What I understand about a limit order in Canadian markets (without an all or nothing option) is that it can sometimes only be partially filled. If you want to buy more of the same ETF then you need to place another trade and pay another commission. Would it then not be more advantageous to consider placing a market order?

  2. Canadian Couch Potato September 13, 2012 at 10:36 am #

    @Philippe: A partial fill is indeed a risk. A couple of times I have had market orders filled at two different prices: had I placed a limit order, I might have received only a partial fill. But if your limit order is a cent or two above the ask price, this should not happen very often at all. If anyone else has experience here, please share.

  3. Aziz September 13, 2012 at 10:47 am #

    The advice on always using limit orders… isn’t that active investing?

  4. Canadian Couch Potato September 13, 2012 at 10:57 am #

    @Aziz: No, not at all. The advice is not to put in a lowball order expecting to get a bargain if the ETF declines in price. In fact, your limit order to purchase should be right at the ask price, or a cent or two higher. This just ensures that you won’t get a surprise.

  5. Canadian Couch Potato September 13, 2012 at 11:30 am #

    Horizons ETFs added the following advice in an email:

    If an ETF is trading at a bid/ask spread that seems particularly wide, it’ a good idea to contact the ETF provider and ask what’s up? All of the ETF providers have customer service representatives. They’ll call the market maker to find out why the bid/ask spread is wide – sometimes it’s a good reason such as maybe some of the underlying securities are hard to find that day. Most of the time the spread will get fixed particularly if they know the order size coming in. All of our ETFs have at least 5000 units of depth in what is referred to as “inventory” available at a decent spread. For most retail investors that’s more than enough.

    What constitutes wide? It’s hard to say. Equities which are more liquid should result in a lower bid/ask spread. Whereas you would expect a higher bid/ask spread on fixed income ETFs.

  6. Andrew September 13, 2012 at 11:34 am #

    I have always used limit orders based on the ask price and use all or nothing feature. When not using all or nothing I have had an order partially filled at my bid price then fully filled sometimes quite later at the same price by the market maker I presume, using inventory.
    I have never had trouble buying low volume ETFs – just have patience. Sometimes it looks like there would be not enough buyers or sellers on a particular day and my order is filled immediately, sometimes I wait a long time and adjust bid in the meantime.

  7. Brunnenburg September 13, 2012 at 11:51 am #

    CCP, you recommended never using a stop loss in a comment on the previous post. I’m guessing because of nasty surprises like the Flash Crash that would trigger the stop loss? Would you recommend then using limit for selling? If so, is there any risk of a partial fill when selling, as is often the case with a limit buy order?

  8. Canadian Couch Potato September 13, 2012 at 11:59 am #

    @Andrew: Thanks for sharing: that’s reassuring to know.

    @Brunnenburg: Exactly: having a stop loss order in place (especially if it was a market order, as opposed to a stop limit order) during the Flash Crash may have resulted in you liquidating an ETF at rock-bottom prices before prices rebounded minutes later. You should use limit orders to sell as well as buy, even if this may occasionally result in a partial fill.

    If you are concerned about a partial fill, you can always set the limit a little further from your desired price: say, three or four cents. Remember, your order will always be filled at the best price possible, so if you put in a limit order to sell at $20 and the current price is $20.02, you will get the higher price. You are not giving anything up.

  9. David M September 13, 2012 at 6:26 pm #

    This is very helpful, but I still have a question or two. Is there any way for the novice to know in real time what the NAV is in order to make an intelligent limit order for a purchase or sale in case the last trade was yesterday or hours ago? Would I need access to level “2″ or “3″ quotations?

  10. Canadian Couch Potato September 13, 2012 at 6:42 pm #

    @David M: The short answer is no, as a retail investor you can’t usually check the NAV in real time. But you should not need to: even if the last trade does not reflect the NAV, the bid-ask spread should. That was the point I tried to stress in the post. As long as your limit order is at or near the bid (if you’re selling) or the ask (if you’re buying), then you should get a price very close to NAV, minus the built-in commission.

    Level 2 quotes can add additional information, however. In answer to a question asked by another reader, an iShares rep wrote the following:

    While the spread for some stocks / ETFs may appear to be 1 cent, this may not actually be the case if you want to trade more than 100 shares. We always advise investors to look at level 2 market data showing the depth of the market rather than just the top order, which may be very small in size (and typically is in the US as the high-frequency trading community is active in most stocks, but only for very small trades). For most ETFs the spread is very tight, but it’s not always possible to get large trades fully filled at the best bid / offer.

  11. Dan Hallett September 13, 2012 at 9:12 pm #

    Great post Dan. This is the kind of stuff that people need to know because the trading mechanics of ETFs are so different than with mutual funds. Great stuff!

  12. Paul T September 13, 2012 at 10:22 pm #

    RE: Limit Orders. Even if you get a partial fill on a limit order, you can always adjust the remaining order to match the bid/ask spread. And it doesn’t count as a separate trade (at least in terms of trading commissions). This only applies for trades in a single trading day.

    If the limit order has a Good Til date, and you get partial fills on two different days, you WILL get dinged with 2 trade commissions.

    I use CIBC Investors Edge and will only use limit orders for most trades. If I only get a partial fill, I’ll wait it out and adjust the limit, if needed, later in the trading day.

  13. gsp September 13, 2012 at 11:06 pm #

    You can check the real time intraday NAV of most US ETFs by adding “.IV” to their stock symbols. For example VTI.IV will get you the intraday NAV for VTI during market hours. You can look up these values on yahoo finance and perhaps some other stock quote websites. Vanguard has standardized these ticker symbols on all their funds, they use to be quite varied. You can find what they refer to as “IOV ticker symbol” on each ETF’s overview page. Other providers have other names for it(Indicative Intraday Value at Schwab, Underlying Trading Value at Ishares) but they all seem to have adopted the .IV convention.

    In Canada this info is rarely provided. I seem to recall Horizon supplying in the past but can’t seem to find it on their site now.

  14. gsp September 13, 2012 at 11:21 pm #

    * I seem to recall Horizon supplying_it_in the past but can’t seem to find it on their site now.

    Be careful relying on this info when trading international ETFs from markets closed during part of the US trading day. The Intraday Value will reflect the price in the underlying stocks held but with the foreign markets closed they will not be able to adjust to new info during afternoon trading in the eastern timezone. This will lead to IV trailing on both large up and down days as the latest info isn’t yet reflected in the underlying securities. The market of course adjusts in real time and participants figure out what effect moves throughout the day on US markets will have on foreign markets when they’ll open the next day. Just a warning that what looks like a great bargain probably isn’t. ;)

  15. Canadian Couch Potato September 13, 2012 at 11:24 pm #

    @Dan H: Many thanks!

    @Paul T: Great information. Any idea whether other brokerages have the same custom (i.e. one limit order with two fills on same day incurs only one commission)?

    @gsp: You know, I have seen that.IV ticker before and had not realized what it was, so thanks for this excellent tip. My guess is that this only exists for well known third-party indexes?

    For funds like HXS in my example above, you can always just look at the S&P 500 index itself. That won’t tell you the NAV in dollars, but it will give you an idea of the relative intraday price movement (up 1%, down 1%) etc.

  16. Brunnenburg September 14, 2012 at 1:37 am #

    Thanks for the detailed responses, CCP. This is the kind of post and thread that makes this blog so vital to Canadian retail investors.

  17. Paul T September 14, 2012 at 8:03 am #

    @CCP I have only ever had a CIBC IE account, so I’m no sure about other brokerages. I find this happens more with thinly traded stocks, or stocks with prices that are quickly rising / falling.

    As well, it sometimes happens when I have an order for an odd lot. IE, I’m buying 243 shares of stock x, 200 might get filled at the ask (2 lots), and the other 43 might sit there until the ask comes back down to my limit, or I adjust up to fill at the new ask price.

  18. CCP Fan September 14, 2012 at 8:26 am #

    At BMO IL (and I believe it is the same elsewhere, as there should be Canadian market rules), you can “modify” an order. Your modification will only go through if your order doesn’t get filled before the modification reaches the market.

    You can modify a partially-filled order. I have done it with a limit order at one time the ETF price went up after my order was partially filled. (I upped the limit by 0.01$ and it went through).

    Modifying an order is not the same as “canceling an order” and “opening a new one”. You’ll get charged a single commission for an order that gets filled during a single day, even if it was modified multiple times and went through many partial fills. On the other hand, you’ll get charged many commissions, one for each new order, if you submit many orders that get filled on the same day, even if it is for the same ETF.

  19. CCP Fan September 14, 2012 at 8:45 am #

    I was wrong. BMO IL’s regular pricing applies the commission on every change to the same order:
    “Commission calculation is based on the original format of the order. If you change an order through a BMO InvestorLine representative, the regular commission schedule applies to the original order and any subsequent changes to that order.”

    The single commission only applies to BMO IL’s flat fee pricing:
    “Trades under Flat Fee Pricing are charged on a per order basis and are not bundled for discounts. For example, where multiple trades are made on the same account for the same security – on the same exchange, the same side of the market and the same day – each trade is charged the applicable commission rate.”

    (Source https://www.bmoinvestorline.com/Commissions/).

  20. gsp September 14, 2012 at 9:01 am #

    TDW also charges just one commission for separate partial fills on the same day even if you change the price of your bid/ask between fills. If the unfilled quantity is quite small, it can make sense to increase your bid slightly in order to save yourself an extra commission the next day.

    CCP, don’t think it is based on the index, I would think it is based on the actual holdings in the ETF.

    Comparing to the previous day’s closing NAV and market price and what the index has done intraday seems to be as close as we can get in this country. That’s how I determine a fair price when buying.

  21. Canadian Couch Potato September 14, 2012 at 12:02 pm #

    @Brunnenburg: Thanks for the kind words, but I think what’s most valuable is hearing from so many experienced investors in the comments. Great stuff, Paul T and CCP Fan.

  22. Que September 14, 2012 at 3:53 pm #

    In the topic of bid/ask values, what does the number next to those values mean (100 & 1600 shown below)?

    IVV
    Bid: 148.01 x 100
    Ask: 148.02 x 1600

    shown: http://ca.finance.yahoo.com/q?s=IVV&ql=0

  23. Canadian Couch Potato September 14, 2012 at 4:04 pm #

    @Que: That’s the numbers of shares in the offer. So in the first case, someone (probably the market maker) is offering to buy 100 shares of IVV for $148.01.

  24. Paul T September 14, 2012 at 4:14 pm #

    @QUE and @CCP. I think it’s the number of board lots available. Usually a board load is 100 shares, so that would be 10,000 shares on the bid and 160,000 on the ask.

  25. Canadian Couch Potato September 14, 2012 at 4:18 pm #

    @Paul T: You’re right. I was thrown off by the large numbers: other than XIU you’re not likely to see any Canadian ETF with 160,000 shares on offer, but with IVV this is probably routine. Thanks for the correction.

  26. dale September 15, 2012 at 9:38 pm #

    great article. I’ve wondered also, how or why do bond etc funds move throughout the day? simply more or less buyers or sellers? news?

  27. SterlingF September 20, 2012 at 1:22 am #

    So I’m just trying to understand the reason to use a limit order. To buy you set it a couple pennies above the ask price so you don’t get surprised by a large jump and be sure to up it a penny or so again if the order is partially filled to get it filled on the same day. I’m in my accumulation phase so I just buy and I don’t care what the price it…I’m in it for the long haul. Am I right in thinking that if it’s higher than a few pennies I could potentially buy one less share or be short on funds if I don’t do this? I think I may have just answered my own question.

  28. Canadian Couch Potato September 20, 2012 at 8:25 am #

    @Sterling: A limit order will not got you a better price than a market order if everything is working the way it’s supposed to. But it will protect you from any surprises if your quote was inaccurate, or the markets spike or fall sharply, or if something really unusual happens like the Flash Crash. Obviously this is not a huge deal if you’re placing a small order, but of it’s large you definitely want to protect yourself.

    Yes, I suppose your buy order risks not being filled if the cost exceeds your cash balance, but you shouldn’t be cutting it that close. :)

  29. Yves September 20, 2012 at 2:27 pm #

    This is a great article!
    But I have a rooky question regarding arbitrage. If we look at “Citadel Income Fund” (CTF.UN), this ETF have a NAV of $4.53 while it sells for $4.25 today. Do you mean that someone could buy it at $4.25 and then sell it at $4.53? How one could sell it’s share for the NAV and to who? Is there something I do not understand?

  30. Canadian Couch Potato September 20, 2012 at 2:41 pm #

    @Yves: Citadel Income Fund is not an ETF: it’s a closed-end fund. That means it cannot create and redeem new shares the way a mutual fund or ETF does. Closed-end funds often trade at a price higher or lower than NAV for reasons of supply and demand, sentiment, etc. But no, you cannot arbitrage this discrepancy.

  31. Ryan_ September 24, 2012 at 11:10 pm #

    Dan,

    Thanks so much for your articles. I’ve read most of your articles and learned a great deal.

    Just an aside though… You say that “The most liquid ETFs have spreads of just a penny”. This isn’t always the case. With higher priced ETF’s you would expect proportionally higher spreads. For example VTI trades at about $75.00 per share, so a reasonable bid-ask spread would be triple that of a similar $25.00 per share ETF. Similarly a $10.oo per share ETF should have a very tight bid-ask spread.

    I believe also, that early ETF companies sometimes give temporary incentives in the form of a MER discount to make up for large bid-ask spreads. Not sure how common this is though.

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