Narrowing Spreads for Illiquids
Traders Magazine, May 2012
"In a fixed-income name or a commodity name or an international name, where the underlying index is closed, instead of getting one principal trader to take on 3 million shares of risk, I can get three to agree to take on 1 million shares of risk each," McOrmond said. "Generally, this tightens the spreads for our clients."
The only way to ensure tighter spreads is through competition. All ETFs go through an incubation process where spreads start out more than a dollar wide and eventually come down over time. If the fund is something a lot of people want to trade, spreads will come down quickly. If it's more of a niche product, the process will take longer.
Alan Alpers, portfolio manager for Niemann Capital Management, a Scotts Valley, Calif.-based shop with $572.5 million in assets, said many market makers post wide spreads because they can't be bothered to closely follow funds that rarely trade. Convincing them there is a live order out there, however, can lead to price improvement.
"Once you wake them up, they tighten up the spreads a fair amount, and you end up getting reasonable prices on most things," Alpers said.
Niemann often works with WallachBeth to ensure it gets better prices than the quoted market. Alpers said he appreciates the anonymity of going through another firm, and getting a two-sided picture of bids and offers.
Though the firm primarily invests in ETFs, less than 5 percent of the funds it uses are difficult to trade. Niemann also tends to avoid the most illiquid names, screening out ETFs that trade fewer than 25,000 shares a day.
The buyside's hesitancy to use ETFs that are lightly traded can cause difficulties for issuers. Investors won't trade funds unless they have a certain amount of volume, but funds can't get volume until investors decide to trade them.
That same problem can be reflected in spreads. If spreads are wide, it scares away investors, and the resulting lack of liquidity continues to encourage wide spreads.
Paul Weisbruch, vice president of ETF/options sales and trading at Street One Financial, said a wide spread creates the perception that a fund isn't liquid-even if hidden liquidity is available. That means the potential price impact for the investor is exaggerated.
"You bring it up on your trading screen, and to see it with a dollar-wide spread, it gives you great pause in using the vehicle," Weisbruch said.
To trade these ETFs, clients have to be in touch with a desk that can tap into hidden liquidity. With some market makers electronically quoting more than 1,000 ETFs, they just can't devote much attention to products that don't trade, Weisbruch said.
Last year, Nasdaq OMX proposed allowing issuers of ETFs to pay market makers for keeping their funds liquid. The Securities and Exchange Commission rejected the initial proposal in December, citing technical issues. Nasdaq revised its filing, and last month regulators published the proposed rule change in the Federal Register, seeking public comment.
Nasdaq said in its filing with the SEC the voluntary program would benefit traders and investors by encouraging more quote competition, narrower spreads and greater liquidity. The exchange stressed the only way a market maker could earn credits under the program would be to maintain a quality market.
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