Things to consider when trading ETFs.

Issue June – July 2012

By Bernardus Roelofs | Global Head ETF Sales Trading | Flow Traders BV, Amsterdam

There are a lot of important facts in ETF trading: Structure of the ETF market, liquidity considerations, differences between institutional and retail investors and trading on exchanges vs. OTC. What investors should be aware of.

While you trade ETFs as easy as stocks and with the same rules there is still a difference. With stocks the bids and offers you see in the market are most often natural interest. There are always people with different views and expectations on companies who want to sell and buy at certain prices – natural interest or natural flow. The ETF market works differently.

Structure of ETFs
The bids and offers you see in the market are most likely from a market maker like Flow Traders, the leading market maker in Europe and Asia-Pacific for ETFs. A market maker provides real time liquidity in ETFs and ETCs and maintains on a continuous basis bid and offer quotes on the exchanges and on an OTC basis. The provision of liquidity by market makers enables investors to be able to execute transactions at all times. As a Market Maker, Flow Traders has committed itself to fulfil the requirements set by Exchanges and the Issuers for the ETF-market segment. These requirements include:

-          Predefined Maximum Spread
-          Minimum Size
-          Presence in the market

→ Market makers are key in providing liquidity for these products.

The liquidity – the Market Maker
The prices, the bids and the offers of an ETF change when the underlying of the ETF changes. Market makers, like Flow Traders calculate the value of each ETF themselves and provide their bid and offer prices around that value. Flow Traders quotes more than 1,700 ETF listings in Europe and is present on all major exchanges. The competition between all market makers is in most cases quite high which means that normally the spreads are tight and the products are trading at their fair value. Some people evaluate the liquidity of an ETF by looking at the turnover on the exchange. This is not the true liquidity of an ETF. The real liquidity of an ETF is its’ underlying or its related future.

For example: A market maker can source the liquidity of a EURO STOXX 50 ETF in its’ underlying or the related future and can use this to hedge himself. So if you trade a EURO STOXX 50 ETF the real liquidity would be the liquidity of a basket of the 50 biggest companies (acc. to STOXX Index rules) in the Euro zone as this would be the underlying. To manage the supply and demand in ETFs, only market makers and authorized participants are permitted to be active in the primary market. This process is called creation or redemption. This means that these parties have the possibility to trade ETFs and ETCs at NAV (plus fees) directly with the issuers. 

Institutional and retail
ETFs are in the focus of Institutional and retail investors. The ETF market has grown rapidly in the last years and is still growing. Some people say that ETFs are the biggest innovation in financial markets since a very long time. The attraction has a reason:  Institutional investors mainly favour these products because of the great liquidity, low fees and the good transparency. Retail clients mainly favour them because of the variety, accessibility and tradability. Simple access to diversification is another reason for both retail and institutional investors. With just one share of an ETF you can get exposure to hundreds of companies. While retail clients tend to trade more often leveraged products, institutional investors most often seek for unleveraged exposure, diversification and asset classes where they want to have a general exposure without having to make a selected pick of just one stock, bond or commodity. They use ETFs for a multitude of different investment strategies. Semi institutional investors, like private wealth management, are looking more and more for active ETFs – ETFs with an active investment approach. This segment in the ETF world will see further growth. While most of the growth in the ETF market in general was driven by institutional investors the last years, retail investors are gaining a bigger role in new assets. They clearly see the advantages of ETFs and want to use them for their own investment ideas.

OTC and the exchanges
There are two ways to trade ETFs: on exchange and OTC (over the counter). When you trade on exchange you will most often trade against a market maker (see 1^st topic : structure of the ETF market). You will seldom know against whom you trade as on most exchanges in Europe you will just see the CCP, the Central Counterparty, which is part of an exchange. When you trade on exchange you have to understand that you have to follow all the given rules from the exchanges, e.g. the settlement cycle or specific buy-in rules. Retail investors should not be concerned as they normally can’t face buy-ins and seldom need flexibility on the settlement cycle. Most institutional investors trade ETFs directly with a market maker. Institutional investors skip their brokers when they want to trade ETFs as they want to trade directly with the source of the liquidity – this saves costs and results directly in better prices and therefore in a better performance of their investment. Most institutional investors trade ETFs OTC and benefit from the ability that a market maker can leverage the on exchange liquidity due to all his hedging opportunities. More than 2/3 of the volume in ETFs all over Europe and Asia-Pacific is traded OTC. There is also more flexibility if you trade OTC as you can negotiate most things related to a trade,  e.g. specific settlement dates or the country of settlement. Institutional and semi institutional investors in Europe and Asia-Pacific can benefit from the advantages of trading on an OTC basis and open a trading line with a market maker like Flow Traders, the leading market maker for ETF in Europe and Asia-Pacific.