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.
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?
@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.
The advice on always using limit orders… isn’t that active investing?
@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.
Horizons ETFs added the following advice in an email:
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.
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?
@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.
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?
@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:
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!
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.
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.
* 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. ;)
@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.
Thanks for the detailed responses, CCP. This is the kind of post and thread that makes this blog so vital to Canadian retail investors.
@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.
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.