ETF Market Making–Very Cool Insider Insights

Have you ever wondered how ETF trading actually works?

Most people think ETFs trade “just like stocks.” These people are wrong. While there are similarities between individual stock issues and ETF issues, there are key differences in how ETFs are traded and how ETFs generate “liquidity.”

To gain some further insight on these issues, among others, we snagged Chris Hempstead and had him answer a few of our burning questions related to ETFs.

Background

Chris is the Head of ETF Sales for KCG and leads the company’s team serving institutions and issuers with their ETF trading, liquidity and market intelligence needs.

Prior to joining KCG in 2013, Chris served as a key member of the WallachBeth Capital ETF cash desk, guiding clients in the design and implementation of ETF trading strategies.

Chris helped us learn about the ETF trading process and is always willing to share his insights on the markets.

Interview:

At http://alphaarchitect.com we get a lot of emails from investors and advisors asking about new ETFs. What are you seeing in the way of new issuance?

Chris: There is no slowdown in the flow of new products coming to market.  While we certainly continue to see ‘sector’ products from new issuers, we have also noticed a real uptick in the ‘smart beta’ and alpha generation product space.  Using long/ short, active management and options overlays have given creative issuers ways to bring new and exciting ETF products to market.

When Vanguard or iShares launches an ETF nobody worries about “volume and liquidity.” But when a new issuer launches an ETF, investors can have concerns? Is this justified? How do you think about volume and liquidity for newer funds? 

Chris:  Believe it or not, the ‘volume and liquidity’ concerns are very real for even the largest and most seasoned of issuers. Granted, a single ETF launch from one of the powerhouses that falls short on volume and liquidity will not be likely to ruffle feathers internally; however, when a new smaller issuer suffers liquidity and volume concerns it can be crippling.

Now, more than ever, new issuers should be aligning with trade desks prior to launch. They should be asking questions of the market makers about expected quote spread, liquidity breakpoints and other trading related nuances. The earlier these conversations take place the better. It is important for new issuers to know this information BEFORE they launch. It will help their salespeople immensely.

What is your opinion on the SECs rejection of some of the Non-Transparency concepts? The structure seems to hinder your ability to make deep liquid markets–is that how you think about it?

Chris:  There are a few proposals out there currently.  One just received a favorable notice while others still have some comments to address. It seems likely that these ‘non transparent’ funds will be here sooner than later, however, the jury is still out on whether or not investors will favor them over traditional mutual funds.

Any advice for new issuers? What can they expect to see on the seeding front?

Chris:  Seeding is important for new issuers but lately we have seen new products come to market with immediate demand from the issuer’s very own client relationships.  This reduces the burden on market makers and makes the entire seeding process more of an operational checklist, as opposed to a balance sheet drag.

There are some who think that if they seed a new product with $100mm it will somehow attract more people. In my opinion, this is urban legend. Investors are doing their homework.  Model managers and RIA’s no longer disregard an ETF simply because of low volume and low AUM.  They are asking questions about ‘true’ liquidity and the costs of buying and selling in large size. Because they are ignoring these aforementioned common misconceptions about ‘investability’ the number of ETFs eligible for inclusion in their models and client portfolios has grown exponentially.

There are variety of market makers and authorized participants in the market–Why should a new issuer go with KCG?

Chris:  KCG is a leading market maker and block ETF desk.  I work with our clients to make sure they understand and are comfortable with our trading approach.  If and when it comes time to trade, we hope that everyone knows exactly what to expect. We take pride in our ability to quote ETFs in the secondary market and we enjoy having regular dialogue with issuers about the activity in their funds.

Not all ETFs are a perfect fit for every market maker, so it is extremely important to have early dialogue with the AP and market making community so that you can find the best partner for your product.  KCG acts in a primary market maker capacity in roughly 650 ETFs.  If you would like to know if your ETF product would be a complement to our offering please don’t hesitate to call. We would be happy to walk you through our process.

I can assure you that you do not want to be in a ‘last minute’ situation regarding lead market maker and seed capital discussions. That will most likely result in the delay of your launch.

Chris’ Final Advice:

Ask questions.  Get comfortable. Ask more questions.  DO NOT let someone tell you that an ETF is illiquid simply because it doesn’t trade a lot.  You are not investing in volume.  You are investing in a product that tracks an index.  If you can efficiently buy and sell the optimal product, other people’s volume is the least of your concern.  Find a broker that understands how to access the cheapest and most efficient liquidity at the moment in time you need to trade.
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Thanks, Chris. I’m sure your advice will be invaluable for new ETF issuers and investors in the marketplace who are looking to get a little more insight on the market making aspect of ETFs.