Understanding ETF trading dynamics: The role of market makers and bid-ask spreads

Overview

Unlike equities, ETF trading is heavily influenced by institutional brokers/investors referred to as authorised participants (APs) or market makers. APs manage the creation and redemption of ETF units in the primary market, leading to ETF flows, specifically the increase or decrease of ETF units on issue, as determined by investor supply and demand. It is a process critical to ETFs trading at parity with NAV.

Market makers, on the other hand, provide price and volume quotes to buyers and sellers of ETFs. Their primary role is to provide liquidity and ensure efficient trading on the secondary market. Market makers seek to generate a profit based on a small arbitrage margin between the price at which the ETF is transacted and the underlying value of the securities that represent the ETF portfolio (the NAV of the ETF).

That margin represents the bid-ask spread. For example, if a market maker is present in the market as a buyer, it will offer a bid price that is marginally below the NAV of the ETF (the bid spread). Assuming the market maker is ‘hit’, i.e. there is not an investor offering a higher bid price, the market maker sells the individual shares with the intent of making a marginal arbitrage profit.

A market maker may also be contracted to maintain a maximum spread. If the market maker is not contracted in this regard, it is still bound by ASX rules in relation to maximum spreads (but these are quite wide) and by minimum bid and ask volume offers. The benefit of a contracted bid-ask spread is it better ensures an ETF remains competitive with other ETFs. Investors should be aware that in periods of heightened volatility, spreads are likely to blow out if there isn’t a contracted bid-ask spread. All ETFs must have at least one market maker unless the ETF has more than 1,000 investors and the issuer is confident spreads will remain tight (i.e., there is sufficient trading volume).

In the case of exchanged traded managed funds (ETMFs or Active ETFs), the fund manager can appoint itself the market maker to avoid disclosing portfolio IP to an external institution. This is referred to as an internal market maker. For the vast majority of ETMFs in Australia, the fund manager is internalising the arbitrage risk in the creation-redemption process. To our knowledge, internal market makers only exist in Australia, and it courted some controversy prior to ASIC’s review of the process in 2019.

Generally speaking, the bid-ask spreads of ETMFs are generally consistently higher than those of ETFs since there is only one market maker (i.e. the responsible entity). On the other hand, an ETF that has an external market maker has a primary market that allows multiple market makers and authorised participants. This promotes competition and tighter spreads. We discuss the internal market making process in greater detail below.

The chart below highlights 3 key patterns:

1) Australian-based ETFs (i.e., ETFs based on Australian securities) are characterised by the thinnest bid-ask spreads.

2) Amongst the equities sectors, bid-ask spreads are the largest for Asian and Emerging Markets mandates (some underlying markets are relatively illiquid).

3) ETMFs are characterised by materially higher bid-ask spreads.

                                             Exhibit 2: All ETF/ETMF Spreads by Sector

                                                 Source: ASX, Foresight Analytics Pty. Ltd.

                                              Exhibit 3: Drivers Determining Bid Ask Spread

There are a range of drivers that determines a bid-ask spread, as we discuss below, and which investors may wish to consider when evaluating an ETF, just as one should do in relation to MERs.

The key drivers are below:

· Intra-day timing - Be conscious of when you trade

· Internal or External Market Making - ETMFs versus ETFs

· Activity - The traded volume of the ETF

· Risk and Information - The nature of the underlying portfolio

· Competition - The number of market makers present

Bid/Ask Spreads – Timing is Everything

In the ETF world, the average bid-ask spread is one of the most widely quoted metrics for liquidity. Despite its usefulness, the average bid-ask spread cannot entirely capture the complexity of the ETF markets. One of its major downfalls is that it obscures the significant variation that can occur in an ETF’s bid-ask spread over the course of a day. Good or bad timing can lead to a major variation in spreads incurred.

While supply and demand vagaries will impact actual intra-day levels, there is a distinct U-shaped pattern in ETF bid-ask spreads during the trading day for ETFs based on Australian equities. Specifically, there are elevated bid-ask spreads at the start of the trading day (10:00 am to circa 10:09 am), which then taper during the trading day, only to increase again in the after-market close ‘auction’ (circa 4:00 pm to 4:10 pm).

For Australian-equities-based ETFs, during the opening of the trading day, ASX stocks open progressively from 10:00 am to 10:09 am in alphabetical order based on their ASX ticker code. Until all stocks in a given Australian-equities-based portfolio are open and have traded, Aps and market makers are ‘flying blind’ to a degree on the NAV of the ETF portfolio. This additional risk is reflected in wider bid-ask offers (spreads) from these market participants.

A similar dynamic exists for Asian-equities-based ETFs, with spreads typically being wider during Australian morning trading while Asian markets are pre-open. They then typically taper as Asian equities markets open. For broad global equities mandates, European-equities-based ETFs or American-equities-based ETFs, the intra-day pattern is less distinct (or not materially present at all) as these markets are generally closed for the duration of ASX trading hours. ETFs are priced by the AP or market maker by way of appropriate futures contracts.

 Internal Market Making – ETMFs (Active ETFs)

Product issuers generally appoint an independent third party that is a market participant to act as lead market maker in order to fulfil their liquidity obligations. However, in very specific circumstances, licensed exchanges may allow the issuer to adopt the role of market maker (i.e. an internal market-making arrangement) on the fund’s behalf rather than using an independent third-party trading participant. Issuers typically use internal market makers if there is a concern that others will use their portfolio IP (for example, by replicating the investment strategy) to the ETF’s detriment.

In July 2019, ASIC placed an official suspension on new ASX listings of Active ETFs that did not disclose their daily portfolio holdings and had internal market makers. A subsequent ASIC review of the industry, 6 months later, identified market integrity issues stemming from certain internal market-making models (where a market maker uses non-public information as part of its pricing methodology) and non-disclosure of daily holdings.

The review ultimately resulted in ASIC lifting the suspension, and publication of the updated INFO 230, designed to manage market integrity risks associated with internal market making.

While ETMFs typically have materially higher bid-ask spreads, investors should note that the profit and loss from such activities are channelled back into the NAV of the ETMF.

Profit and loss from the use of internal market making represent the difference between the amount an investor traded, based on the ASX price, and the amount an investor could have applied or redeemed, based on the vehicle’s unit price (entry price and exit price for that same trade date). Therefore, the profit or loss is attributed to the ETMF’s NAV. Nevertheless, it remains a cost to the particular investor that is trading.

It should also be noted that the applicable average bid-ask spreads in ETMFs are approximately comparable to a fund manager’s unlisted unit trust version of the trading strategy. A cynic might be tempted to say that a fund manager could widen spreads at certain times as a disincentive for investors to redeem. However, it should be noted this is a conflict of interest that ASIC requires product issuers to disclose and manage.