Narrowing Spreads For Illiquid ETFs
Traders Magazine Online News, May 3, 2012
In certain cases, your trading costs are going to go way down, because youre trading the actual basket, which is usually more liquid than the ETF vehicle, Glownia said.
Of course, not everyone wants to take on market risk. One of the benefits ETFs offer over mutual funds is the ability to trade intra-day, so investors can respond to changes in the market.
Glownia said there can be another problem with this method, too. Usually the creation-redemption process has a minimum of 50,000 shares or more. Investors looking to trade fewer shares might not have access to that process, in which case theyll have to look elsewhere.
The agency shop WallachBeth Capital has built a niche for itself with ETFs that trade in lesser quantities. Though liquid ETFs can be plugged into algos without much of a problem, less liquid ones cannot, so WallachBeth takes a high-touch approach to its trading. The firm uses an ETF desk of 12 traders to find liquidity that doesnt show up on the screen.
Andrew McOrmond, managing director at WallachBeth, said if a broker only calls one or two people, and counterparties know there isnt much competition for that order, they wont get the best price. But when a firm calls 22 people, he said, and their counterparties are aware of this, firms on the other side tend to give their best price rather than dangle an outlier number in hopes of catching a big spread.
Much of the liquidity for ETFs comes from arbitrageurs. McOrmond said these liquidity providers are valuable for price improvement, but traders should also keep in mind that they make their livings off of spreads.
Principal traders can increase profit in ETFs as an arbitrage trade with a wider spread, said McOrmond. That is why clients need a good broker to get better prices, he added.
Each individual product has its own characteristics. Knowing where to go for liquidity and how to trade each ETF is important for best execution.
In ETFs, there is so much more liquidity available than what actually trades on a daily basis, ADV, McOrmond said. It starts with a diversified liquidity pool. Then you add negotiating and real-time pricing experience and you have true access to it.
Some market makers are not available to public customers, as they can only trade with broker-dealers. Others may have liquidity to provide, but only a small amount. Shops like WallachBeth find that liquidity, aggregate it and provide it to the customer.
For more information on related topics, visit the following channels: