Friday, May 28, 2010

Fidelity Customers and iShares ETF's: the Impact of Commission-Free Trades

On February 2, 2010, Fidelity announced that their clients would be able to buy and sell a select group of 25 iShares ETF's commission-free, in addition to Fidelity's NASDAQ Composite Index Tracking Stock. The move follows a decision by Schwab offer commission-free trading on a select group of proprietary ETF's. Fidelity offers a larger number of commission-free ETF's than Schwab, plus the strong reputation of iShares.

In an earlier analysis of Schwab's commission-free arrangement, we studied the quality of trade execution at UBS, a major venue (technically, market center) for executing orders on Schwab ETF's. Even though UBS executes a large volume of orders for Schwab ETF's, other "ETF complexes", such as State Street, Vanguard, and PowerShares, exhibited better trade execution than the Schwab complex. This analysis of the iShares trade execution complex will follow a similar theme.

Morningstar appropriately asks in their commentary who really benefits more from the Fidelity-iShares arrangement: Fidelity or iShares? Their assessment concludes both parties win. Fundometry expands the audience to include investors who enter those commission-free orders. By looking at iShares ETF's which trade commission-free and those which do not (most of the iShares ETF's), we can compare execution quality with respect to the commission as well as time (before and after February 2010).

Fidelity is not a leading venue for trading iShares, or some of the other major ETF complexes. The following two graphs show how much volume was executed at NFS (Fidelity) versus other market centers. ETF complexes are selected from the top five traded ETF's, in terms of share volume over six months, at each market center. (Two graphs are better than one because the market centers range widely in terms of volume, hence the horizontal scales are different to accommodate the higher and lower volumes.) Someone entering an order through Fidelity to buy or sell an ETF (not only those from iShares) may hope the order is routed to another market center which handles a larger order flow, hence sourcing more liquidity and hopefully achieving better price execution. For those iShares which trade commission-free at Fidelity, the graphs show the volume for those respective tickers in a lighter shade, even though the actual trades may have incurred a commission if entered from brokerages other than Fidelity.

Interestingly, if an ETF order is entered from Fidelilty and gets routed to NFS, there appears to be a near certainty strong probability that the order will be executed at NFS. The following two graphs compare how much of the order flow was executed at the specified market center as opposed to being routed to another market center where a better price existed. NFS is not the only brokerage with a tendency to keep orders internal; Knight, Citadel, and Barclays also show no red bars.

Although NFS handles a relatively small volume of orders for iShares ETF's, order flow does not appear to route to other market centers which may offer deeper liquidity. Why? Perhaps because NFS does not need to route an order to another venue if it can execute at a price better than or equal to the National Best Bid and Offer (NBBO). Unfortunately, the following graphs, utilizing the same source data as the above graphs, do not readily support that explanation.

The above two graphs show the breakdown of share volumes according to execution quality during each month (October 2009 through March 2010): improvement (better than the quote), at the quote, and outside the quote (degradation). NFS (Fidelity), Knight, Citadel, and Barclays tend to execute orders themselves rather than route to other market centers (as stated earlier). Over the sampled period, Knight and Citadel exhibited noticeable price improvement for the tickers which Fidelity customers can trade commission-free. Barclays achieved price improvement to a lesser extent but executed a decent amount at the quote. In significant contrast, NFS showed a worsening trend in terms of execution quality. NFS substantially exceeded its competitors in executing outside the quote, a trend which dramatically increased in January and persisted through March. Why would Fidelity offer to not charge commissions for iShares ETF's for which it could not achieve better execution (even when charging commissions)?

Perhaps some more insight can be derived from looking at the other iShares ETF's which Fidelity still charges its customers to trade.

Once again, Knight and Citadel demonstrated a degree of price improvement, outpacing Barclays and NFS. While Fidelity charged a commission for trading the ETF's sampled in the above two graphs, the extent of price degradation was even higher than those ETF's which trade commission-free. In March, trades executed at NFS exhibited a higher rate of price improvement than in preceding months, and trades executed outside the quote subsided yet remained at a high level. Given that trading activity at these market centers are compared for the same group of ETF's and over the same period, the above graphs do not explain how Fidelity's customers (trading iShares ETF's commission-free or not) are winning with respect to execution quality.

Corresponding comparisons for some other major ETF complexes paint a similar picture: Direxion, PowerShares, and ProShares.

While many trades executed outside the quote, to what extent was price impacted? In other words, how far outside the quote did NFS fill orders? Since price impact (in dollars per share) is disclosed separately for trades where price improved and degraded, a weighted average, based on their respective share volumes, can be computed. The following graphs display the share volume in each market center for iShares ETF's which trade commission-free at Fidelity and the corresponding weight-average price impact ("WAPI").

In terms of WAPI, NFS once again stands out from its peers. NFS consistently achieved adverse (negative) overall price impact throughout the six-month period. As indicated above, the trend worsened after December. A peer with comparable volume, Barclays, also exhibited adverse WAPI but to a lesser extent than NFS and without significant trend. Among the largest market centers, BATS and Direct Edge exhibited adverse WAPI but to a much lesser extent than NFS. (Differences in the volume of specific ETF's at each market center explain some of these variations, but in general NFS did exhibit consistently more adverse WAPI versus BATS and Direct Edge among specific ETF's. If interested in more details, please submit a comment below requesting more information.)

The following graphs display the share volume in each market center for iShares ETF's which Fidelity charges its customers to trade and the corresponding weight-average price impact ("WAPI").

The performance across market centers is consistent with the iShares ETF's which trade commission-free at Fidelity. BATS, Direct Edge, Barclays, Knight Equity Markets, and NFS exhibit adverse WAPI. However, BATS, Direct Edge, Barclays, and Knight followed an improving trend over time. In terms of WAPI, only NFS achieved more adverse WAPI from late 2009 to early 2010.

Similar graphs for other ETF complexes similarly show NFS achieving increasingly adverse price impact over time, in contract to most peers. If the above graphs are not sufficient, click on the following ETF complexes to open a few more: Direxion, PowerShares, and ProShares.

In conclusion, while the arrangement between Fidelity and iShares does make tremendous sense from a marketing perspective, the quality of trade execution leaves much more to be desired. For financial advisors or long-term investors who prefer using ETF's, the price impact may not be meaningful enough to diminish the cost savings from zero commissions, as long as trades are not too frequent. Conversely, for day traders, the economics of avoiding a commission may not offset adverse price impact while executing an order at NFS (assuming that a Fidelity customer does not have the option of specifying at which market center to execute). As with any analysis of vast amounts of data, the results have varying relevance depending on individual investor circumstances. Nevertheless, one cannot help but wonder if NFS will improve its trade execution quality for ETF's - regardless of whether a commission is charged or not.

A few important details concerning the data utilized for this analysis:
1. The above graphs compare data gathered from Rule 605 disclosures from approximately a dozen market centers (trading venues). Those venues are selected based on the Rule 606 disclosure from National Financial Services ("NFS", an affiliated broker-dealer of Fidelity) which lists to which market centers Fidelity routed equity orders during the first quarter of 2010.
2. The Rule 605 disclosures for each market center (except for BIDS Trading) are used to analyze trade execution quality over the six month period from October 1, 2009 through March 31, 2010. Data at the individual ETF (ticker) level is aggregated according to the sponsoring firm (e.g. iShares, State Street, PowerShares).
3. The above graphs reflect only market and marketable limit orders. While other types of limit orders are frequently used, Rule 605 disclosures report execution quality for only market and marketable limit orders. To see a table summarizing activity by order type, click here.
4. Aggregated figures may not be ideally comparable across market centers and ETF complexes (sponsoring firms). Each market center has a different share of the trading volume for each ETF which impacts the comparison of execution quality across different market centers and during different months. Furthermore, not every market center has necessarily executed trades in every ticker within an ETF complex.
5. Weighted average price improvement may reflect some biases due to the differing prices of ETF's. Higher priced ETF's may have orders filled with greater deviations from the quote than a lower priced ETF. Conversely, lower priced ETF's may trade in larger share volumes than higher priced ETF's. The weighted average considers both the impact on price, in dollars, weighted by the corresponding share volume. Orders filled at the quote are included in the weighted average with an assumed price impact of zero.

Thursday, May 6, 2010

Treasury Temporary Guarantee Program: Update on Potential Costs to the Uninsured Investors

On September 18, 2009, the Treasury's Temporary Guarantee Program ("TGP") ended. This program provided a form of government insurance on participating money market funds. A few posts in November 2009 reviewed the manner in which payments to the Treasury (insurance "premiums") were calculated and charged by participating money market funds. The primary focus here is who paid for the insurance and who could have received any payments from the coverage.

While premiums were paid directly by the funds, the funds used their fees assessed to all money market fund investors, including any investors who did not qualify to receive a monetary benefit from the insurance. Investors in a participating fund would be covered by the TGP capped at the invested balance as of September 19, 2008 (the "Cut-Off Date"). In other words, even though premiums were charged at the fund level, coverage was defined at the specific account level and based on a specific time. This arrangement is akin to paying premiums for a mandatory employer-sponsored group insurance plan but not being covered if the employment started past a certain date.

Even people who invested in a money market fund as of the Cut-Off Date would not necessarily be fully covered by the TGP. If such an investor held $1,000 on the Cut-Off Date but subsequently invested another $2,000, only the initial $1,000 would be covered. In fact, coverage is not transferable across different funds. If the same investor redeemed the initial $1,000 which was covered and used the proceeds to invest in another money market fund, coverage would not apply to the new investment. An earlier post more clearly explains the details of how coverage was extended with respect to the Cut-Off Date.

The data to track who individually invested in money market funds, including when and by how much, is not publicly available. Even brokers possessing this information would probably require a non-trivial amount of effort and expense to retrieve such data. In order to demonstrate the monetary cost to investors who paid for the TGP but were not covered, we can utilize public data on cash flows for money market funds and derive some useful estimates from a model.

Based on the monthly sales and redemptions for registered money market funds, the model estimates how much of the fund balances originated from investments made before and after the Cut-Off Date. The results below exclude funds which invest primarily in Treasurys and Government debt. Several such funds decided not to participate in the TGP for the full term since, by investing in only Federal government-backed debt, the Treasury guarantee was implicit, hence additional insurance was deemed redundant. Therefore, the sample population of funds in this analysis comprises those which invest in CP, corporate bonds, municipal bonds, RMBS, ABS, and repurchase agreements, in addition to some possible amount of Treasurys and Federal agency debt. In order to expedite the modeling process, only funds with assets over $1 billion are included, and we assume such funds represent a majority of the population.

The results are broken down by three main scenarios. Across all scenarios, investors are assumed to redeem from money market funds in proportion to their balances. For example, if $100 million were invested in a money market fund prior to the Cut-Off Date, out of a total balance of $400 million for the same fund, then the model would assume that 25% of redemptions would be deducted from the $100 million portion. Of course, this "ratio" changes over the modeled time period, from September 19, 2008 through September 18, 2009, depending on how many investors purchase and sell a money market fund after the Cut-Off Date.

In the first scenario, the model assumes that purchases of a money market fund are as likely to come from investors who are covered (insured) by the TGP than those who are not covered (uninsured). Accordingly, in the numerical summary below, the split in Average Monthly Sales (82.6% insured vs 17.4% uninsured) closely matches the split in Average Monthly Balance (81.4% vs 18.6%). As highlighted by the green box, investor balances not covered by the TGP paid 9.6% of the total premiums in this model scenario.

In the subsequent graph, which shows the trend in the insured and uninsured balances over the modeled time period, the monetary cost to investors who are not covered by the TGP is proportional to the size of the red bars versus the green bars.

In the second scenario, the model assumes that purchases of a money market fund are twice as likely to come from investors who are covered by the TGP than those who are not covered. When comparing the split in Average Monthly Sales (45.4% insured vs 54.6% uninsured) against the split in Average Monthly Balance (65.7% insured vs 34.3% uninsured), we observe a greater tendency for sales/purchases to come from investors not covered by the TGP. As highlighted by the green box, investor balances not covered by the TGP paid 28.2% of the total premiums in this model scenario - equivalent to $188 million for the sampled population of $1.9 trillion in fund assets.

Accordingly, the graph corresponding to this second scenario shows a larger proportion of bars colored red than in the first scenario.

In the third and final scenario, the model assumes that purchases of a money market fund are four times as likely to come from investors who are covered by the TGP than those who are not covered. When comparing the split in Average Monthly Sales (25.7% insured vs 74.3% uninsured) against the split in Average Monthly Balance (49.9% insured vs 50.1% uninsured), we observe an even greater tendency for sales/purchases to come from investors not covered by the TGP. Investor balances not covered by the TGP paid a substantial 44.7% of the total premiums in this model scenario - equivalent to $298 million for the sampled population of $1.9 trillion in fund assets.

This scenario may be somewhat extreme but interesting nevertheless. In the corresponding graph, the proportion of red bars versus green bars shows the increasing amount of TGP premiums paid by investors who invested in a money market fund after Cut-Off Date.

While TGP premiums were paid to the Treasury only on specific dates, we assume that money market funds amortized that expense over time and spread the cost out beyond the date when premiums were paid. Regardless of when an investor made initial or subsequent investments, whether before/after Cut-Off Date and before/after premium payment dates, the fund assessed its fees consistently across all investors. Whether investors in a money market fund paid for some portion of TGP premiums after its termination on September 18, 2009 is a question beyond the scope of this analysis and beyond the scope of data available.

We cannot estimate an exact monetary cost to investors who, by definition of the TGP, would not have been eligible to receive payouts from the Treasury in the event a money market fund suffered losses from defaulted securities or otherwise could not fully repay investors. However, from these scenarios, we get a sense of the relative magnitude of this cost. The green box in each of the numerical summaries above indicates how insured and uninsured investors split the modeled cost of TGP insurance. Investors not covered under TGP might have paid $64 million under a reasonable scenario, to as much as almost $300 million in an extreme scenario. Without access to additional data from account-level records, one cannot perform a more accurate and conclusive analysis. (For a money market manager curious on how such an analysis would work, please contact the author at

This analysis should lead to further questions and potential ideas for how such a program could have been funded in a more equitable manner. Please feel free to post comments and feedback below. Check back for a future post showing how an actual money market fund (which invests in Treasury securities) participated in the TGP for the full term even though a vast majority of investors purchased the fund after the Cut-Off Date.