How NOT to Execute Your ETF Block Order..Best Ex Memo

Editor note: For those who didn’t get the”Best Ex Meets Worst Ex” memo,  Ugo Egbunike from IndexUniverse spotlighted a block trade in QAI this past Monday that was apparently mangled by the executing broker, illustrating once again that ETFs are NOT stocks, and real best execution requires guidance from a truly-professional trader that actually knows how to execute ETF orders.

Someone got taken to the cleaners on Monday, buying 16,000 shares of  QAI—a trade that highlight the nuances of market-on-close (MOC) orders. They could have avoided it. Here’s what happened, why and how you can avoid it.

At 4:00:00 p.m. ET, around 16,000 shares of the IQ Hedge Multi-Strategy Tracker ETF (NYSEArca: QAI) were executed at $28.83—that’s $1.28, or 4.64 percent, more than its last traded price of $27.55 at 3:59:59 p.m. Eastern time. It was completely unwarranted.

At 3:59:59 p.m. ET, someone was offering 12,800 shares at $27.56. The fund’s underlying value didn’t change in that one second. At the end of the day, its net asset value was $27.50.

* NYSE Arca Market Closing Price                                                                        Source: Bloomberg

The trade was the result of a poorly executed market-on-close (MOC) order. MOC orders for NYSE Arca-listed ETFs are automatically entered into the NYSE closing auction, which is outside of the core trading session.

Unfortunately, orders in the NYSE closing auction are exempt from Rule 611: the Order Protection rule.  The basic idea behind the rule is to protect investors from faulty trades by comparing all nationally placed quotes.

If a better price exists for a market order, it gets routed to that exchange before it can get traded at its current exchange. In the case of the MOC trade in QAI, there was no protection—the trade was exempt because it occurred during the auction and not during the regular trading session.

It seems likely that the buy order was entered as a market order into the MOC NYSE closing auction. Had it been a limit order, the buyer’s limit would not have been $28.83, which means the final execution price would have been great news. Given that the last price was $27.55, a market order must have been behind that terrible trading strategy.

After a buy order is entered, NYSE alerts market makers that wish to participate in the closing auction. From there, market makers can begin to enter competitive quotes to match the buy order. The algorithm behind the auction system considers the size of quotes as well as the price.

A market maker can enter 100 shares offered at $27.55, but should another market maker offer 30,000 shares at $29.00, more than likely, they’ll get the bulk of the order. There are no second chances in the system. If you enter a market order into the auction, you’re trusting that there will be competitive quotes and adequate size as well.

In the case of QAI, a market maker was willing to match the 16,000 shares that the buyer needed. However, at 4:00 p.m., they were only willing to do so for a price of $28.83—and no other market maker was really there to compete with them. Frankly, you can’t blame the market maker, either. This was a $500,000 transaction—you need some type of competitive edge to justify the trade.

At 4:00 p.m., if a market maker has to deal with the burden of hedging out QAI, he’s going to want a good amount of edge. That’s especially when you consider that most of the securities that make up QAI are ETFs that probably aren’t very liquid after the market close. QAI also holds futures and swaps based on emerging markets indexes and real estate funds.

It’s not necessarily rocket science to hedge these things, but it’s also not ideal to do so after core trading hours. So again, anyone doing the trade is going to want some kind of edge to offset the additional risks and challenges of an after-hours trade. This isn’t the SPDR S&P 500 ETF (NYSEArca: SPY) that you’re hedging.  It’s a fund that barely trades one creation unit—50,000 shares—per day.

There are a few lessons to be learned here. For one, stay away from market orders in general. Structuring limit orders based on the current inside market is a far better strategy than simply shooting blind. It’s OK to let the market maker come to you. With the current market structure these days, you have no idea of what may occur in the next second—or millisecond.

Secondly, intraday trading isn’t so bad, as long as you keep the indicative intraday NAV in mind and you try not to show your hand.

Whoever placed this buy order in QAI would have been much better off executing the transaction buying in smaller lots during the day or even using a volume-weighted average pricing algorithm.

Thirdly, if you need to place an MOC order, understand the market and dynamics of the security you’re dealing with. QAI is no SPY, so you’re probably better off talking to someone at Knight Capital or WallachBeth Capital about getting a fair deal for a block trade.

In some cases, relying on your own MOC order is akin to shooting in the dark—especially for an ETF that trades under 100,000 shares a day on NYSE Arca.

Unfortunately, whoever was on the buy side of this trade won’t see their money for a long while. Since inception, QAI has broken the $28 range once. The fund isn’t designed to be a blockbuster, it’s a hedged strategy.

The buyer can’t break the trade either. NYSE does have a price collar on how far closing auction prices can be from the last traded price. In this case it would have been 5 percent—that’s a 0.36 percentage point difference from where the trade was actually executed. So close, yet so far away.

It gets worse. Take a look at the table above. A market maker on Nasdaq probably saw the trade go through on NYSE, and added some salt to the wound. That market maker offered 18,000 shares at $27.60 right at 4:00 p.m. ET—maybe in hopes that the buyer wasn’t done with the order.

So learn from the mistakes of others—no one wants to end up as another person’s lesson.