ETFs in the morning? Traders take warning

March 8, 2021

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Jim Rowley, CFA, Head of Investor Research Vanguard Investment Strategy Group

Jim Rowley, CFA
Head of Investor Research
Vanguard Investment Strategy Group

For millennia, seafarers have adhered to a version of this saying:

"Red sky at night, sailors' delight."
"Red sky in the morning, sailors take warning."

That was before scientists explained how high-pressure systems can trap particles in the atmosphere, appearing red in the sunlight and signaling potential weather to come.

In a similar fashion, ETF investors have long lived by a comparable saying: Avoid trading in the morning and near the close.

This adage is grounded in the idea that market makers will be less confident of prices in the morning and near the close, which can widen bid-ask spreads, possibly costing investors unnecessarily when they trade.

At Vanguard, these rules have been considered best practices for ETF trading . . . until now.

Only half true

Our recent research has shown, however, that unlike the red-sky proverb, this adage is only half true. The data seems to suggest that ETF investors have reason to avoid trading early in the morning, but the data do not show any reason to avoid trading at the close.

Now we offer an updated ETF version of the old saw for advisors:

"ETFs at last light? Spreads are reasonably tight."
"ETFs in the morning? Traders take warning."

Our latest paper, Examining Intraday Fixed Income ETF Liquidity: Is it more expensive near the open?¹, was published in The Journal of Index Investing in December.

The study is a follow-up to our 2019 research paper², also published in The Journal of Index Investing, which found that bid-ask spreads for U.S. equity ETFs tend to start the day trading wider but are actually tightest in the late afternoon.

Before looking at the data, we wondered whether the "avoid the open and the close" rules of thumb were urban legend, bits of wisdom passed along over the years but with scarce data to confirm their veracity.

Data to the millisecond

Accessing Bloomberg market data down to the millisecond, we examined 168,324 bid-ask spread observations of 166 U.S. fixed income ETFs, over 78 intraday intervals in 13 quarters. Specifically, we looked at only traditional U.S. bond ETFs based on national best bid and offer (NBBO) spreads.

We found that spreads tend to begin each day at a high point, fall throughout the morning, and then remain generally flat through the end of the day. While that was true during quarters when markets seemed relatively quiet, it was also true during more volatile periods such as the first quarter of 2020 (see figure below).

Average bid-ask spreads during the day for U.S. fixed income ETFs

(First quarter 2020, in basis points)

The image shows the average daily bid-ask spreads for U.S. fixed income ETFs in the first quarter of 2020. In the chart, bid-ask spreads typically began the day above 50 basis points, then fell to below 20 basis points by 10:15 a.m. They then remained at that level through the rest of the trading day.

Source: Vanguard calculations using data from OneMarketData LLC.

Our research controlled for differences in category. In other words, the pattern seen in the figure below remained, even after controlling for the fact that some ETFs focus on government bonds, while others focus on high yield, municipals, etc.

Fixed income spreads across various categories

Spread (bps)AverageStandard deviationNumber of tradesNumber of ETFs

All fixed income ETFs

12.91

15.70

168,324

166

U.S. government

8.05

9.96

40,560

40

Investment-grade

13.61

14.18

86,190

85

Broad credit

15.58

13.70

14,196

14

High-yield

16.55

24.19

27,378

27

Municipal

16.01

14.91

27,378

27

Non-municipal

12.31

15.78

140,946

139

Volume (USD)

574,132

2,449,462

168.324

166

Note: Values derived from cash observations in each time interval in each calendar quarter from the first quarter of 2017 through the first quarter of 2020.
Sources: Vanguard calculations, using data from OneMarketData, LLC, and Morningstar, Inc.

In addition to recommending that you avoid trading in the morning, we believe that these best practices can help ensure trades are executed at the best available price:

  1. Consider using a limit order. By specifying the price you are willing to pay to buy, or sell, and no more, you can ensure that unexpected market volatility won't cause a trade to go through at a much higher price. Yet if prices move in your direction, you can still benefit. Other order types can help you trade with greater precision.
  2. Call your block desk. When executing large orders, there's no shame in calling on the trading experts at your firm to help.
  3. Beware of volatility. You probably check the weather before leaving on a trip, right? It's just helpful to keep an eye on the market before you trade.
  4. Understand liquidity. An ETF's average daily volume doesn't best reflect its liquidity. Because ETF shares can be created or redeemed, the liquidity of the underlying securities in the creation/redemption basket matters the most. When the underlying securities are difficult to trade, the market maker's costs may increase, resulting in wider bid-offer spreads.

If you can follow these rules, you're likely to face less choppy waters for all your ETF trading.

¹ James J. Rowley Jr., Haifeng Wang, and Eric L. White II, Winter 2020. Examining Intraday Fixed Income ETF Liquidity: Is it more expensive near the open? The Journal of Index Investing 11(3):21–33. Winter 2020.© [2020] Pageant Media. Republished with permission of PMR (Portfolio Management Research) Journal of Index Investing. All rights reserved.
² James J. Rowley Jr., Charles J. Thomas, and Ryan E. O'Hanlon, Spring 2019. Examining Intraday ETF Liquidity: When Should Investors Trade? The Journal of Index Investing 9(4):6–17.

Notes:

  • All investing is subject to risk, including the possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.