Narrowing Spreads For Illiquid ETFs
Traders Magazine Online News, May 3, 2012
In some cases, aggregation can be the key, especially in ETFs that track tricky asset classes that force arbitrageurs to take on risk. Allowing counterparties to cut back on their own risk means they will likely be able to provide a better price.
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 its 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 cant 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 buysides hesitancy to use ETFs that are lightly traded can cause difficulties for issuers. Investors wont trade funds unless they have a certain amount of volume, but funds cant 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 isnt liquideven 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.
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