Narrowing Spreads for Illiquid ETFs

Excerpts Courtesy of James Armstrong/Traders Magazine

For some illiquid exchange-traded funds, the price isn’t always right. Spreads can be unreasonably wide, luring the less informed to take the bait and accept a price that is far from reasonable. Fortunately, those spreads are slowly narrowing due to competition.

With illiquid funds, the screen does not always match what an ETF is really worth. If a fund rarely trades, both the bid and the offer will be posted by professional trading shops and will be skewed to a premium or a discount. That means spreads can be more than a dollar wide at times.

Even if liquidity is present, it’s not showing up in the posted prices. Recent data from Index Universe shows more than 10 percent of ETFs still have spreads of 100 basis points or more. The vast majority of those funds have an average daily volume of fewer than 5,000 shares.

Many in the industry are trying to help investors who want access to these lightly traded ETFs but don’t want to get soaked every time they buy or sell. Gradually, they are starting to get some of those spreads down to more reasonable levels, though certain funds still have a way to go.

High-Touch + High-Tech Approach

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 combines high tech with a high-touch approach to its trading. The firm uses a highly-sophisticated trading technology platform to support its ETF desk of 12 traders to find liquidity that doesn’t 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 isn’t much competition for that order, they won’t 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. 

Andrew McOrmond, WallachBeth

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.

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 it’s more of a niche product, the process will take longer.

Alan Alpers, Niemann Capital

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 can’t 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 buyside’s hesitancy to use ETFs that are lightly traded can cause difficulties for issuers. Investors won’t trade funds unless they have a certain amount of volume, but funds can’t 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.

For the entire TradersMagazine article, click here.