By Ari Weinberg | November 26, 2012    

Pension fund managers considering expanding their use of exchange-traded funds must always bear in mind that trading ETFs is entirely different from trading stocks.

Entering a transaction without a clear understanding of the market dynamics for the ETF and the underlying stocks can be costly without the right precautions. The market impact can be more than the fee in basis points cited in the funds’ materials.

“The implementation of a trade is very important and, in some cases overlooked,” said Tim Coyne, head of ETF capital markets for State Street Global Advisors in New York. SSgA sponsors nearly $300 billion in U.S. exchange-traded products. Only in the past few years, with the surge in ETF issuance and trading, have market makers and institutional agency brokers begun to offer ETF-specific implementation shortfall models.

One of the selling points for ETFs is that they can be more liquid to trade than their underlying constituents, but this is only the case in a handful of funds, said Alex Hagmeyer, vice president for data analytics at Markit in Naperville, Ill.

Estimating market impact — the spread from arrival price to final price — to include the notion of ETF creations and redemptions can be complicated by market conditions. And the dynamics of ETF trading have several brokers and data analysts refiguring their implementation shortfall estimates, taking into account that liquidity in the ETF is not the same as the total liquidity available to the investor.

For pension fund managers passing through ETFs in a manager transition or when adding a liquidity layer in broad-market ETFs, market impact models may seem a distant concern but basis points on large transactions can add up.

“A lot of ETFs are quoted by market-making algorithms,” said Chris Hempstead, director of ETF Execution at WallachBeth Capital in New York. For this reason, the impulse to get filled instantaneously by sweeping the limit order book can have a negative impact on an ETF trade.

Mr. Hempstead paints a scenario of an ETF order for 10,000 shares — 1,000 shares filled at the displayed price and 9,000 a nickel away. “If the quotes fill in around your trade (back to the original price), you probably paid too much,” said Mr. Hempstead.

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