***Originally published in the July 2011 edition of NAAIM’s “The Active Manager” By Scott Freeze.
Best Execution is a very difficult metric to measure since it is such a subjective benchmark. In a “thinner” ETF with a wide spread, such as MNA (IndexIQ Merger Arbitrage), you have a 20 cent spread and very low volume. If you buy on the offer, or sell at the bid, this would be construed as “best execution”, but a position bid (where your broker fills you on the whole order, immediately, at one price) should fill you within the NBBO. (See 43,190 MNA sold on May 25th within the spread). If you consider beating the VWAP/TWAP to be “best execution”, what happens when you beat VWAP/TWAP by 5 cents but have 20 cents of market impact in beating the VWAP/TWAP? For many investors these dilemmas are solved by trading exclusively with their custodians or getting position bids. So, what is the best way to trade ETF’s and achieve Best Execution?
While algorithmic styles such as VWAP/TWAP have been considered as acceptable practices by many investors, many advisors and custodians have sought to minimize their trading costs and market impact by seeking position bids on their trades. The argument that has been made is that by sourcing liquidity and finding a counter-party to “put up the trade” at one price, the investor is getting best execution. While this may be true in some regards, such as the MNA trade example above, in many cases this is an extremely ineffective way to trade, and is the polar opposite of best execution.
The examples of when position bids achieve less than “Best Execution” and why. Selling In A Rising Market/ Buying In A Falling Market:
Since most ETFs (there are caveats depending on if the ETF is domestic/international equity based, fixed income, commodity, or otherwise based) trade around the IIV (Indicative Value) of the underlying basket of securities, asking or taking a position bid for a sell order in a rising market not only takes you out of the market at significantly lower prices than you can achieve but also creates a volume spike that skews your benchmarks. Conversely, taking a position bid to buy an ETF in a falling market only achieves an immediate execution at a worse price than you would receive if you waited a few more minutes. While all of the above would seem to be very obvious to an educated investor, there is still a hidden side of the position bids that impacts an investors’ execution. This would be “Rebates” or “Payments for Order Flow”. The ETF Industry relies on Authorized Participants (AP’s) and Market Makers (MM’s) being enabled to trade the underlying basket of securities in the ETF and converting the underlying basket to ETF shares for the client. In many cases, these AP’s and MM’s will pay a rebate to the executing broker as an enticement to get the order. This rebate is added into the client price, so the investor does not see the rebate being paid out, but it is baked into the execution price. For example, if you buy 50,000 shares of XYZ as a position bid and your execution price is 25.69, and your broker received a penny rebate, then your buy order would have been filled at 25.68 (or less as discussed later) and you paid the extra penny rebate through higher execution costs, as well as your broker commission. This does not only affect institutional customers such as Investment Advisors, but retail customers as well.
If you are a retail investor and trade through your custodian, and your custodian receives rebates on your orders, while you do not pay a per share commission, your execution price is still impacted by the rebate that is baked into your fill and paid to your custodian. As a retail investor buying smaller share amounts the cost of paying a rebate is not as great as for institutional investors, but the costs for Institutional Investors is much larger than just the rebate.
These examples assume that a client is paying only a penny a share as a rebate back to the client. While that may be the case, the price received may not only be skewed by a penny. For example, when pricing an ETF for position, some firms will have different pricing for rebated versus no rebated orders. In selling MNA an AP indicated a price to sell at 25.25 without a rebate, but 25.22-25.23 with a penny rebate added in. The price to the institutional investor is not always skewed by only a penny because the broker is receiving a penny rebate. But in the following example we will assume a penny rebate and penny commission to outline the potential costs to the Institutional Investor and their clients: Assuming the Large trade on May 17 was a position bid with a rebate Institutional Investor sells 3.4 million shares of EWY as a position bid around 11:12. The bid is about 63.75 and the order is filled at 63.60. If the broker was rebated a penny, and paid a commission on the trade, they received $68,000 in compensation for the trade with the investor paying $34,000 and a minimum of $34,000 in a lower execution price. Assuming the price to the client was only impacted one penny for the rebate, that client lost 1.57 basis points on that trade, not including the fact that there was 15 cents of market impact. The ETF closed at 63.95 that day, and the Institution in essence paid 2 cents per share to execute the trade. I’m sure the Institution considers their fill to have met Best execution, but in the above scenario it would have been AT LEAST 1.57 Basis points away from best execution, andmost likely over 3 basis points away from where it should have been executed. This is a high dollar value stock, where the basis points missed is going to be lower, can you imagine the number of basis points you give away to rebates on lower priced stocks? Or the cumulative result of losing 3-5 basis points on every trade you do for a year. You would lose 3-7% off your annual performance just because you paid your broker or custodial desk, rebates on top of commissions. That is 3-7% of your assets that you do not get paid on, and a reduction in your performance number when you are trying to grow your business and attract more assets. With all of these examples, how can an investor truly achieve best execution? For one, make sure your custodian goes to counter parties for pricing and does not receive a rebate for the flow. If trading outside of your custodian, make sure your broker informs you of the rebate they received on the trade (if any), and do not trade exclusively on position bids. Your broker is there to work for you. Make your broker seek best execution through the marketplace, over time and with position bids if necessary as a combined strategy to get you—the client—the best price, not to pay the broker twice as much in compensation. Recapturing basis points through better executions is the broker’s job, not to double your fees paid to the broker. You built your business and you are the one who should reap the greatest rewards from it. It will benefit you, the advisor, in the long run through better performance numbers, being easier to attract new assets and having a larger AUM.
Scott Freeze is the President of Street One Financial. Scott has been involved in ETFs from both a trading/execution and a product strategy standpoint since the beginning of the decade. He brings his relationships with RIAs and institutional portfolio managers to Street One where he helps construct better portfolios, and recapture basis points that would otherwise be lost in the marketplace, through better trade execution. Scott holds the Series 3, 4, 7, 24, 53, 55, and 63 licenses.