Narrowing Spreads for Illiquids
Traders Magazine, May 2012
Though traders in the know can often receive better prices than what is quoted, the proposal aims to give all traders access to the best markets possible.
The idea has received initial support from issuers, market makers and authorized participants, but it is unclear whether it will ever be approved by the SEC. In the meantime, investors wanting to trade certain ETFs would be well advised to find traders who won't just take a quoted price on a screen at face value.
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According to Street One's Weisbruch, clients need to use a brokerage that has expertise in trading illiquid ETFs, that know not just how to get the trade done, but also how to get prices close to the value of a fund's underlying assets.
"The majority of buyside managers are still trading these as if they were stocks," Weisbruch said. "It creates a huge opportunity for those on the other side of the trade, for high-frequency traders and statistical-arbitrage-type hedge funds."
These players jump into trades and arbitrage away the difference, but if the managers had a little bit more information, there wouldn't be quite as much opportunity for the arbitrageurs to cash in and reduce alpha for the buyside, Weisbruch said.
Education the Key
Buysiders might be tempted to pick a midpoint between the posted offer and bid, but the value of the underlying assets in an ETF could be much closer to one than the other. In such a case, executing at the midpoint could leave the buyside getting soaked.
Weisbruch said the more difficult a basket is to assess, the more difficult the ETF is to trade, but being able to quickly and accurately assess the value of the basket can help traders know what the price should be.
"You have a vast amount of misinformation on the institutional front," Weisbruch said. "Education is improving, albeit a little bit slower than we would like it to."
SunGard's Fox River Execution has also tried to better educate the buyside on lightly traded ETFs. That way, managers can decide for themselves if the bids and offers posted are justified.
Paul Daley, head of product management for Fox River, said to identify the fair price of an ETF, a trader has to have data about the underlying assets of a fund and be able to process that data in real time.
"There are some cases where the bid-offer spread is justified, and then there are other cases where it is not, but distinguishing between those two just by looking at the spread is a near impossibility," Daley said. "You have to look at what is going on in the underlying securities."
Fox River offers real-time data for the underlying basket, arguing it is necessary for traders to have that data so they can protect themselves with limit orders.
"You are paying a commission to a broker for a reason," Daley said. "You need that broker to set intelligent limits for you, and if they're not doing that, find one that will."
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