ETF Capital Markets Desk: A Voluminous Responsibility

    David Mann

    David MannHead of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments

    In prior Capital Markets Corner posts, David Mann, our head of capital markets, Global Exchange Traded Funds (ETFs), has been discussing the concept of arbitrage, including arbitrage bands. Here, he discusses the groups responsible for generating an ETF’s trading volume on any given day.

    First, thanks for all of the questions you send in about the posts! I love the discussion, which helps me think about these topics in different ways and just as importantly, helps drive future Capital Markets Corner posts.

    I had received a couple questions asking why an ETF might trade beyond its arbitrage bands given everything we know about ETF arbitrage. I promise I will answer this question (most likely in my next post) but to do so, I need to answer a different and seemingly simple question first: Who is responsible for an ETF’s volume on a given day? I would categorize the participants into three groups.

    Group 1:  ETF Investors

    This includes anyone—from the smallest retail investor to the largest institution—who wants to invest in an ETF because it offers exposure to a particular asset class. The investor has an opinion on how a certain market or strategy will perform and will buy an ETF he or she thinks may go higher and sell those he or she thinks may drop.

    Group 2: ETF Market Makers

    “Market Makers” includes firms that calculate what they think an ETF is worth, then provide two-sided price quotes around that value. Different firms may have different methods for determining what the ETF is worth. For example, some may only use the price of the ETF’s underlying basket of securities, while others might use other correlated instruments like index equity futures or even the price of other ETFs.

    The main takeaway is that this group does NOT have an opinion whether a particular asset class will go up or down but DOES have an opinion about what the ETF is worth. Their business model is to earn the difference between the price of the ETF and the price they think the ETF is worth and then use the creation/redemption facility to manage their inventory.

    Group 3: High Frequency Stock Traders

    Like the ETF market makers, this group is continuously providing two-sided price quotes throughout the day and also will NOT have an opinion as to whether a particular asset class will go higher or lower.

    However, this group does NOT care what an ETF is worth. They tend to only be active in the most highly traded ETFs and treat them like any other listed stock. Their business model is to buy and sell as much of an ETF as possible—ideally in equal amounts—and then earn the bid/ask spread of the ETF. As mentioned earlier, these firms tend to trade only the most liquid ETFs as defined by average volume and their quotes will be driven by market demand rather than by the underlying value of the ETF.

    All of an ETF’s volume will come from one of these three groups, but as you can imagine, their interest in a particular ETF can certainly vary. ETF market makers might be less interested in a US domestic ETF that trades perfectly in line with its intraday net asset value (NAV) since there is no difference between the price of the ETF and what they think it is worth. The high-frequency traders will typically not be interested in lower volume ETFs because there are not enough shares to buy and sell throughout the day to fit their business model.

    So, let’s go back to our original question. Why might an ETF trade outside its arbitrage band? This really boils down to the breakdown of which of the three groups above is driving the majority of the volume.

    In my next post, I’ll put the concepts related to ETF arbitrage and market participants together, and give my take on what this all means for investors.

    David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

    This information is intended for US residents only.

    To comment or post your question on this subject, follow us on Twitter @LibertyShares and on LinkedIn.

    What Are the Risks?

    All investments involve risks, including possible loss of principal. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.