Friday, April 9, 2010

In Search of Price Improvement for Schwab ETF's

When Charles Schwab sold its capital markets affiliate to UBS in October 2004, the industry took notice of the impact: UBS gained significant market share in NASDAQ equities trading as well as the sizable equities order flow from Schwab's customers. Schwab does not receive rebates or other payments from UBS. Nevertheless, part of the consideration Schwab received for the sale was a commitment to route orders through UBS for eight years, starting in 2004.

Normally, Schwab charges a commission for trading equities and options. However, on November 3, 2009, Schwab announced the launch of their proprietary ETF's as well as their unprecedented $0 online commission rate for Schwab clients.

Does this no-commission/no-rebate arrangement have any impact on order flow or order execution? Comprehensive details are not easy to collect, but the following analysis is an attempt at providing some insights from data which is available.

This analysis utilizes Rule 605 disclosures for the following exchanges and ECN's ("market centers"): UBS, NASDAQ, NYSE Arca, BATS, DirectEdge, Instinet, Knight Capital, and Citadel. The sample period covers November 2009 through January 2010. Other market centers executed or routed orders for Schwab ETF's, but this sample accounts for 72% of the trading volume over the sampling period.

Below, we look at various statistics among some of these market centers with a specific focus on UBS.

(Note on the following graphs: Individual ETF's are aggregated according to their sponsoring firm into "ETF complexes". Although the selected ETF complexes have trading volumes larger and smaller than that of the Schwab complex, Schwab's ETF volume should fall roughly in the center of the distribution. Shown next to each ETF complex is the aggregate volume, over the sample period, expressed in millions of shares. The graphs do compare ETF complexes with varying amounts of liquidity, but one can isolate those with similar trading volumes by noting the figures in parenthesis.)

What happens when a broker (assumed to be Schwab) routes a Schwab ETF order through UBS?

We observe how many shares are traded at market centers other than UBS, out of all shares routed and traded through UBS. Few other ETF complexes get such exclusive treatment by UBS, certainly none as large as the Schwab complex. UBS traded fewer shares of First Trust, Rydex, and WisdomTree ETF's (10.4, 9.3, and 11.9 million shares respectively) than Schwab (17.3 million shares) yet routed more of their orders to other market centers.

What happens when a Schwab ETF order is routed through other major market centers?

If a market center cannot fill an order at the best price (national best bid and offer, or "NBBO"), then that center should route the order to another venue where a better price is available. On that basis, other market centers don't seem as capable as UBS in achieving best trade execution for Schwab ETF's. Perhaps this makes sense if the investors trading Schwab ETF's are mostly Schwab clients. As seen above, although NYSE Arca handles orders representing 2.1 million shares of Schwab ETF's, it routes almost 10% of those orders to other market centers where better prices are presumed to have been available.

How well did UBS fill those orders which it chose to handle internally (i.e. not route to other market centers)? Given the data available, we can look at how many shares were executed inside the quote (known as "price improvement"), at the quote, and outside the quote. The following graphs display the percentage of shares which fall into one of these "three tiers" of execution quality. Most orders are either market orders or marketable limit orders. Therefore, we report the two types separately since there may be inherent differences between the manner in which market orders and marketable limit orders are executed. One would especially hope for price improvement on market orders, but no worse than filling at the quote.

Given that UBS executed almost all Schwab ETF's orders internally, it is interesting to see how UBS fills market orders. Among complexes of comparable trading volume, Schwab ranked quite low on price improvement. UBS achieved the best price improvement for iShares ETF's, at about 75% of the total 228 million shares traded with market orders. First Trust ETF's, with a smaller volume of 9.1 million shares traded with market orders, still saw price improvement for 65% of that order flow. UBS achieved price improvement for Schwab ETF's for about half of the 14.7 million shares traded with market orders. The results for at the quote and outside the quote fills are respectable, but nothing special either.

For marketable limit orders, UBS handled Schwab ETF volume of 2.6 million shares. Price improvement ranked somewhat better across the same sample of ETF complexes, but not by much. Approximately 3% of shares traded with marketable limit orders saw price improvement, while almost all others were executed at the quote. UBS achieved the best rate of price improvement for Victoria Bay ETF's with a higher volume (24.6 million shares). ETF's from First Trust and Rydex, with 1.3 and 1.6 shares traded respectively, saw better rates of price improvement even though their volumes are smaller than that of Schwab ETF's.

The same statistics are available at other market centers. Results can be skewed depending on the order volume handled by each market center. Hence, the initial table, showing volume of executed orders by market center, may be a helpful reference.

In comparison to other ETF complexes, NYSE Arca executed market orders and marketable limit orders for Schwab ETF's with modest price improvement, which falls near the lower end of the range. Note that the volume of market orders is very small, only 0.1 million shares of Schwab ETF's executed and no more than a million shares for any other ETF complex. The volumes for marketable limit orders was higher, with 2.0 million shares of Schwab ETF's executed, and Schwab ranked roughly in the middle of the distribution.

Similarly, Schwab ETF's traded on NASDAQ with very little price improvement, but nevertheless ranked near the middle of the range among other ETF complexes with comparable volumes. NASDAQ did not disclose any statistics for market orders.

For orders executed at BATS, Schwab ETF's received the most-frequent price improvement for marketable limit orders in comparison to peers, while price improvement seldom occurred for market orders. Out of 0.8 million shares traded in Schwab ETF's with marketable limit orders, BATS achieved price improvement for approximately 12% of the order flow. While this percentage is much lower than the rate of price improvement achieved by UBS, Schwab ETF's ranked better than other comparable ETF complexes for marketable limit orders executed at BATS.

While digesting these graphs, consider these additional factors.

1. The trading activity spans only three months, although all market centers and ETF complexes are compared over the same period. Schwab launched its proprietary ETF's in November 2009, hence relevant activity does not exist for prior months.

2. Only online orders entered through Schwab are commission free. Orders entered through other channels (e.g. phone) are not advertised as commission free, even though those orders would likely be executed through UBS. The available data does not provide any information on the order entry method. Hence, this analysis assumes that the majority of Schwab ETF's orders routed through UBS were entered online.

3. Other attributes may differ between orders routed through UBS and orders routed through other market centers. No details are available on actual limit prices on limit orders, and the specific execution times and applicable NBBO's are not provided. However, further analysis can be performed on the amount of price improvement at the ticker level.

Execution quality is challenging to track and measure. The summarized data used in this analysis attempts to compare execution quality among major market centers at the level of ETF complexes. While not digging into finer levels of comparison (ticker level or specific month), this analysis demonstrates that Schwab ETF orders routed through UBS almost exclusively get executed at UBS and generally with less frequent price improvement than orders executed at UBS for other ETF complexes. Nevertheless, the other market centers in the sampled data exhibited even less price improvement.

UBS probably has an advantage versus other market centers due to its sizable portion of order flow for Schwab ETF's, even though other ETF complexes with smaller volumes (such as Claymore, WisdomTree, and Rydex) achieved more frequent price improvement at UBS. On the other hand, UBS achieved price improvement for other ETF complexes (such as iShares, Vanguard, PowerShares) to a greater extent than for Schwab ETF's even though a larger portion of orders were routed to other market centers.

Would paying a commission in order to trade an iShares ETF have resulted in more cost-effective execution than paying no commission to trade a Schwab ETF? The answer may depend primarily on order size and the frequency of trading. This analysis is not exhaustive and cannot be conclusive, but the sampled data demonstrates that paying no commission when trading an ETF might not always result in the lowest overall execution cost.

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