ETF Expert Corner

KCG’s Phil Mackintosh Discusses Best ETF Trading Practices, ETF Liquidity

May 23rd, 2017 by ETF Store Staff

Phil Mackintosh, Head of Trading Strategy & Analysis at KCG, discusses best ETF trading practices and explains key considerations when evaluating ETF liquidity.


You can listen to our interview with Phil Mackintosh by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: It's important to remember that the “E” and the “T” in ETF stands for “exchange traded”, which means you have the flexibility to buy and sell ETF shares during the day, just like you can with individual stocks. But with that flexibility, also comes some additional responsibility. You want to make sure you're getting the best possible price when buying or selling ETF shares and you also want to make sure that you're protecting yourself in more volatile markets. Joining us on the program today is Phil Mackintosh, Head of Trading Strategy and Analysis at KCG. KCG is one of the world's largest independent market makers and they are a major player in ETF trading. They work with big institutional investors who leverage KCG's expertise to make large ETF trades. Phil is joining us via phone today from New York. Phil, welcome to the ETF Store Show.

Phil Mackintosh: Hey, guys. Thanks for having me.

Nate Geraci: Phil - we're going to get into some important tips on ETF trading, but let's start today with some basic blocking and tackling on ETFs, and my hope is we can keep this as straightforward as possible which, admittedly, isn't always the easiest thing to do on radio. ETFs obviously own baskets of securities. For example, the SPDR S&P 500 ETF, ticker SPY - it holds the stocks of 500 of the largest U.S. companies. To begin here, explain for our listeners how the share price for SPY is actually determined during the trading day.

Phil Mackintosh: I guess, in reality, the share price of the ETF is determined by supply and demand, but the thing about ETFs is that arbitrage will come in when the supply and the demand make the ETF mispriced vs those underlying stocks. So really what we should be concerned about is, just like you said, there's a portfolio of 500 shares in the ETF, and you can value that portfolio. Every morning, there's a number that you divide that value by, which basically converts the value of the portfolio into a share price, which is the ETF share price. So you know from what's called the NAV, or the net asset value, what the value of that portfolio is in ETF shares. That's really what everybody runs off is - is what the NAV value should be of the ETF price.

Nate Geraci: Can you explain the concept of premiums and discounts on ETFs and, perhaps, how they're rectified?

Phil Mackintosh: The one thing about a NAV, or a net asset value, is it's actually a valuation of the last price of all of the underlying stocks in the basket. When you're an arbitrageur or when you're looking at whether the ETF is mispriced, the ETF itself has to actually be richer than the basket of stocks offer or cheaper than the basket of stocks bid, so the spread of the basket is also important in working out when arbitrage comes into the market. An ETF could be, if the fair price of SPY was $200, it could be trading at $200.01. That would be $.01 rich, but the actual arbitrage level might be $200.05, so the arbitrage for stocks might actually kick in a little bit rich vs the NAV that you see, but pretty close to the actual ETF price.

Jason Lank: Phil - this is Jason Lank. You're really traveling down a path I wanted to continue on. You talk about premiums and discounts. How far away from the actual does that premium or discount have to go before it gets arbitrageurs' attention? Is it a penny, literally, that they can make money scalping that, or does it need to be wider? And does it really depend on what kind or the liquidity of the ETF involved?

Phil Mackintosh: It depends on a lot of things. For a start, the ETF obviously, like we've been saying, has to be richer than the actual stocks in the basket. So a lot of the stocks in the basket have different spreads, but it also has to be richer enough to cover all the costs for the arbitrageur, so they've got to trade all the underlying stocks and settle them and then pay for creation fees. Liquidity will be a factor. The actual basket creation cost will be a factor. The underlying basket spread will be a factor. For a ticker like SPY, the underlying basket spread is about 3 basis points, so you'd probably see arbitrage less than 2 basis points to either side of NAV. For a ticker like IWM, the underlying basket spread is actually closer to 40 basis points, so you'd think that you'd see arbitrage actually 20 basis points rich or cheap, but what actually happens in reality is there's also a secondary group of arbitrageurs that will trade one ETF vs another ETF or futures vs ETFs, especially for an ETF like IWM, which is the Russell 2000. You'll actually see the arbitrage much earlier than that 20 basis points, plus or minus versus NAV, and it typically trades much closer to the midpoint of the underlying basket price.

Nate Geraci: Phil - we were talking about calculating the share price for an ETF like SPY. What about ETFs holding international stocks, so something like the iShares Core Emerging Markets ETF, ticker symbol IEMG? Obviously, this ETF trades on the U.S. exchanges during the day, but many of the markets for the underlying stocks are closed, particularly in the afternoon. How does an ETF like IEMG price during the day?

Phil Mackintosh: That's a really important question because the net asset value is obviously going to be calculated off stocks that haven't traded for hours. In reality, sometimes this affects bond and commodity ETFs, as well, which have different market opens and closes or different underlying liquidity. A lot of the bonds in bond portfolios don't trade every single day, so some of their prices can be really quite old. What market makers do in all those instances is they've built statistical models which help them approximate what the value of the ETF should be right now. They'll make markets and hedge with instruments that are pretty good hedges, but obviously not perfect hedges. We actually did a study where we looked at how well the market makers guesstimate those future values for the ETFs, and we found that the mispricing on international stock ETFs was around $.01 per share so, really, they're very good at estimating how much rich or how much cheap the ETF should be, based on all of the new news since the markets have closed. It's basically, if you cross the spread, you would be paying the right price for the ETF.

Nate Geraci: One other quick foundational question here before we get to some basic ETF trading tips - every stock and every ETF has what's called a bid price and an ask price. Can you, perhaps, explain what those are and why they're different?

Phil Mackintosh: The bid is obviously the highest price that someone's willing to buy any stock for and the offer is the lowest price that anybody's willing to sell a stock for. Because sellers want to sell high and buyers want to buy low, you'll have a gap between that, which is known as the spread - so the bid is lower than the offer, and that's the spread price. A lot of what we've been talking about this morning, we're saying 2 basis point spreads, that's 0.02 of 1%, so it's really tight spreads, and it's not going to impact your returns on most investments very much at all if it's that level of spread.

Jason Lank: Phil - on the same subject of the bid-asks, what are some of the factors that determine that? Is it the volume of, for example, an ETF like we're discussing, or is it more about the liquidity of the underlying, the size of the underlying? What are some of the factors involved?

Phil Mackintosh: I think one of the biggest factors involved is how easily you can hedge the ETFs. A lot of the illiquid ETFs you see onscreen will actually be trading $.01 or $.02 wide, even though they've got not much liquidity and might not even trade more than two or three times in a day. That's because the arbitrageurs or the market makers can price the ETF really efficiently and hedge it really efficiently, as well. One of the other factors that we do see factoring into spreads is the cost of the creations and redemptions. If it's more expensive to do a creation, that kind of gets built into the spread. Some of the less liquid ETFs, where you're only going to create one unit at a time and maybe once a week, have slightly wider spreads just to account for that.

Nate Geraci: Our guest today is Phil Mackintosh, Head of Trading Strategy and Analysis at KCG. Phil - now that we've covered some of the basics, let's talk about best ETF trading practices, and probably the easiest place to start is just with the process of actually placing an order to buy or sell an ETF. Investors can place an order at the market price of an ETF, or they can set the price they wish to buy or sell at using a limit order. Walk us through some of the considerations here.

Phil Mackintosh: I think limit orders are really important for people to use. Most of the ETFs, like we've been talking about, are priced really close bid-offer spreads, and their market makers are very good at setting the right price, but the last thing you want to be is the guy who puts a 2,000 share buy order in and pays $5 more than the last price. I think the thing you want to do when you're ready to trade is to look at the NAV and that asset value and work out from that where you're willing to actually set your limit. The other thing you want to do is to look at the quantities that are on the offer and what the spread is. You don't want to cross a $1 spread if you can help it, so it's handy to know that that spread is $1 but, more importantly, if there's only 100 shares on the offer and you've got 2,000 shares to buy, you definitely don't want to put a market order in just in case there's not any shares at higher prices than that offer of 100 lot. In those instances, that's when limit orders are really important, so you might think that the offer is a fair price, but you take that 100 shares and then post the balance of your buying at that price on the limit. One of the things that a lot of people probably don't realize, though, is that a lot of retail orders, the way the American markets work, are actually routed by the retail broker dealers to market makers who are held to execution standards. Typically, what you'll actually see for most of your orders that you send to a retail broker dealer is you'll get filled inside the spread by the market makers, and you won't actually have ... even if you used a market order, you won't have to worry about blowing through the book and causing upsets in the markets. I guess if you've got a larger trade, that's a nice problem to have. ETFs can trade like a portfolio, and that's when a lot of our clients come to us because we can do creations and exemptions, and we can buy the underlying stocks and convert that to the ETF for the clients, and that's often a better way to trade really large trades.

Nate Geraci: Phil - when it comes to using limit orders, does it matter the type of ETF? For example, if I'm buying an S&P 500 ETF versus, let's say, a Frontier Market ETF, should I always use a limit order regardless, or do I just need to use it in a less efficient market, like with a Frontier Market ETF?

Phil Mackintosh: I think limit orders are a good best practice in all instances but, obviously, in a less liquid ETF that's got less people looking at it, there's more risk that a market order will actually trade or push the price way up from where the last price traded. Something like S&P 500, SPY, is going to have a lot more offers on the other side of the spread that you'll have to trade with before you cause disconnect, but I just think limits, you don't have to use a limit at the bid. You can actually use a limit $.03 or $.04 richer than the offer. You just want to make sure that you don't accidentally trade $1 rich.

Nate Geraci: That's a good point. I guess, what is the best way to determine the price to use on a limit order? Especially if you're an everyday investor who wants to make sure you're protecting yourself, but you also want to make sure your trade actually gets executed and isn't just sitting out there because the limit order price happens to be outside the bid ask. What is the right balance here?

Phil Mackintosh: If you're happy to cross the spread that you see when you're looking at the market right now, I think you should use a limit that's at least at that offer level, maybe a couple of cents higher because I think, to your point, you're really just making sure you're protecting yourself. You want to get the fill, but you don't want to be the guy who causes the ETF to trade $20 rich on a 400 lot, which we do see every so often. If you just look at the NAV, work out where the market's at, and pick a level that's roughly in line with those levels, just so that you're not the guy that pays 10% too much for the ETF.

Nate Geraci: One other quick question regarding best ETF trading practices, what about the time of day? Are there better times than others during the trading day to buy and sell ETFs?

Phil Mackintosh: That's a really good question because, when you think about it from a market maker's point of view, if they're really good at providing liquidity into the market when they're doing arbitrage, they need the markets to be all open, so they need all of the underlying stocks to be tradable, hedgeable pricing so that the NAVs can be calculated so that the bid and the offer values of the basket can be calculated. For that reason, I would really try and avoid the auctions, which is the open and the close, just because those are times where the supply and demand is really the only factor driving the ETF price. It's much harder to make markets into those particular times. A lot of people say wait until 10 a.m. to start trading, and that's because the spreads are a little wider in the morning. There's more volatility in the morning although, in reality, that volatility and spread settles down pretty quickly, so 9:40 is probably long enough to wait for the continuous markets to be settled down. The other thing that we do see from our studies is that more ETFs trade rich and cheap versus their underlying basket in the last 30 minutes of the day. That's not necessarily a reason not to trade, but it might be a reason to use tighter limits or to think twice about just trading in that last half an hour.

Jason Lank: Phil - I'd like to relate to you an actual experience I had while trading that happened to involve your company. We were in a position where we needed to purchase a fairly significant number of shares in an ETF that had recently launched. The volume was fairly light and, as it turns out, the bid ask was pretty wide. I spoke with our custodian and asked them to see if they could make a deal for me. Is there a way for us to cut down the bid ask so that we can purchase the shares more favorably for our clients? Got a call back 10 or 15 minutes later, and the deal got done. I said, "That's great. Who was it?" The custodian said, "Well, we made a call to KCG." This was before, actually, I knew you were going to be on the show. Obviously, the client wins, and we win, and everybody's happy. Is that a typical experience that professional or investment advisors might have with KCG?

Phil Mackintosh: I'd like to hope it's always what's going to happen with KCG, and I'd like to hope that, when people have difficult trades to do, they don't just use the exchange and the markets to do them. That's a classic example of when having an expert with all of the live prices of the underlying basket available to them to know what the actual costs are can really help an investor. What typically happens with those new, less liquid ETFs is the market makers don't know how many days they're going to wait until they actually have a creation basket, but if you've got one trade that is actually a creation basket, then a lot of the problems of holding the position go away for the market maker. So being able to know your exposure and just deliver the underlying stocks into a creation basket can often save a lot of money for an investor. It makes it much easier to sharpen the pencils, as we would say on the floor.

Nate Geraci: Our guest today is Phil Mackintosh, Head of Trading Strategy and Analysis at KCG. Phil - I want to spend just a few moments on ETF liquidity, which we began to touch on a little bit earlier. For many investors, they equate higher trading volume with better liquidity so, for example, if Apple stock trades 25 million shares a day, investors assume it has better liquidity than a stock that maybe trades 25,000 shares a day. Obviously, that impacts the bid ask price but, with ETFs, it's not always as simple as that. You can't just look at daily trading volume. What should investors be looking for when evaluating how liquid an ETF is?

Phil Mackintosh: That's one of the common misconceptions about ETFs. If you think about the U.S. large cap stock universe trades about 70 billion dollars a day. The small cap universe trades about 12 billion dollars a day. The underlying baskets in a lot of these less liquid-looking ETFs are just as liquid, or more liquid, than the most liquid ETFs in the same category. When you can do creations and redemptions overnight, you can access all of that underlying basket liquidity really quickly. So it's really important not just to look at the screen liquidity, which is the ETF ticker liquidity – but if you really like an exposure for a ticker, an ETF, but it doesn't look liquid on the screen, call the desk, find out how liquid the underlying basket is and how easily you could get a large trade done. It's usually a lot easier than people think.

Nate Geraci: What about new ETF launches? We recently crossed over 2,000 ETFs. There's another 2,000-plus ETFs in registration with the SEC. We continue to see a parade of new ETFs coming to market. Purely from a trading perspective, should investors wait to purchase a new ETF or, again, does it simply get back to the liquidity of the underlying holdings?

Phil Mackintosh: In terms of getting in and out of the ETF, there's no need to wait because the market makers will have the inventory. These ETFs have been seeded so that there is shares available, and we can always do creations and redemptions, it doesn't matter how old the ETF is. There's no reason to wait to get into the product. Obviously, we can do a creation and redemption at the value of the underlying spread so, usually, it's pretty cheap to get into even brand new ETFs. I guess the only thing that you do take on is a little bit more due diligence on an ongoing basis, just to make sure that the ETF stays alive and continues to accumulate assets because there have been studies done that show that the smaller the ETF, the more likely it is to experience closure risk. The risk of closure can be expensive if you don't realize the ETF's going to close and sell the ETF before it actually does close on you.

Nate Geraci: Alright, Phil, lastly before we let you go, as I'm sure you're aware, there's been a lot of discussion recently regarding mismatches in liquidity between ETFs and their underlying holdings. In particular, I think areas like bank loans and high yield bonds come to mind. Should this be a concern? Could we see some sort of dislocation in the market because of ETFs?

Phil Mackintosh: I've been starting to call this #fakenews because the reality is, the underlyings, even in those markets every day, is in the billions of dollars. For most people, there's no concern. We've seen a couple of trades in products like HYG, which is high yield debt, in the multi-billions, which have been split over multiple days, which is a sensible way to exit a multi-billion dollar trade in HYG. That spread the trade out enough that the market could absorb that liquidity. The only real example of something to watch out for and, again, another reason to use limits, was the crowded trade. In August 24 is a classic example where, what we found in the morning of August 24, was retail was sellers of about 10 billion dollars' worth of stock and ETFs in the first minute of the day, which is way more selling, and it's actually quite a lot more volume than you'd typically see in that first minute, which kind of overwhelmed the market. It's a classic example. You don't know, as an individual, that you're going to contribute to a crowded trade exit but, if you're using limits, what you tend to find when the markets disconnect like they did on August 24 is, if you could've avoided that 15 minutes of disconnection, things did return to fundamental levels, and you would've been able to trade later in the day at fair market prices. Sometimes having a limit and not trading can be safer than trying to trade with everybody else when there's new news out.

Nate Geraci: Phil, I think if we could sum up our conversation today, I think it would be to make sure you use limit orders when buying or selling ETFs and, obviously, look to the liquidity of the underlying holdings of an ETF if you want to see just how liquid it is. We'll have to leave it there. Just tremendous insight into ETF trading and liquidity, I think certainly helpful for any ETF investor. Thank you very much for your time today.

Phil Mackintosh: You guys are welcome. Thanks for having me.

Nate Geraci: That was Phil Mackintosh, head of Trading Strategy and Analysis at KCG.