What does a market-maker do?

Unlike mutual funds, ETFs trade throughout the day. This activity requires intermediaries, known as market-makers, who adjust bid and ask prices ato reflect the value of the ETF’s underlying securities.

A market-maker’s day usually begins between 6 a.m. and 7 a.m.

The previous night, after markets closed, ETF providers calculated each fund’s net asset value (NAV) and compiled a portfolio composition file (PCF). The file contains the creation and redemption baskets, showing market-makers exactly which securities and the quantity of each that’s needed to create or redeem a unit of the ETF, said Prerna Mathews, vice-president of ETF product strategy with Mackenzie Investments in Toronto.

Market-makers will use the PCF when the market opens to estimate a bid and an ask price for ETF investors. They spend the pre-trading hours reviewing the PCFs and inputting the information into their trading algorithms, Mathews said. They’re also digesting what happened overnight, such as macro events, as they try to determine how markets may look at the open.

Opening bell

Market-makers take the opening 15 minutes of every trading day to ensure an ETF’s underlying assets are accurately priced. Mathews said investors should avoid trading while this process plays out. “Let the markets settle,” she said.

Keeping an ETF’s bid-ask spread up to date and facilitating trades between buyers and sellers is the market-maker’s primary task during the trading day. Trading screens show what the buyer is willing to pay and what the seller is demanding. The difference is the bid-ask spread.

As the ETF’s underlying securities move up and down in value, the market-maker rolls the bid-ask for those individual securities into the bid-ask for the ETF. Market-makers earn money on the spread: because a security’s value could drop between the time they purchase it and sell it, they’re compensated for the risk of holding the asset and creating liquidity.

Competition between market-makers at different firms helps ensure prices are fair, Mathews said: another market-maker will undercut you “if they see a price on screen is not reflective of the value of the underlying exposure.”

Market-makers create ETF units by delivering a basket of underlying securities to the ETF provider in exchange for a block of units, usually 50,000. To process a redemption, the market-maker returns the ETF units in exchange for the securities.

A few factors can affect the bid-ask spread. One is the liquidity of the underlying holdings. Large, frequently traded stocks tend to have narrower bid-asks, so an S&P 500 ETF will have a narrower spread than a small-cap fund. ETFs holding a smaller basket of securities also may have wider spreads because price movements are more pronounced across fewer holdings.

Funds that use hedging require more complex trading (and therefore costly) strategies from market-makers, which may translate into wider spreads. And bonds, which are sold over the counter, often have less transparent prices, also contributing to wider spreads.

Finally, funds holding international securities are more difficult to price since markets are closed for part or all of the Canadian ETF’s trading day. “Market-makers are using a lot of different proxies to value those underlying emerging market securities,” Mathews said. Those proxies include foreign exchange markets, futures markets and macro news.

An exceptional day

Spreads can widen for any ETF when the liquidity that market makers provide becomes more expensive. The widening can be moderate and short-lived, as sometimes happens around Federal Reserve announcements, or it can be more severe and enduring, as it was in March 2020 during the onset of the Covid-19 pandemic and after Russia invaded Ukraine last year.

“[Markets] don’t know what’s coming next, so you will immediately see risk priced in,” Mathews said, which widens bid-ask spreads.

Macro events tend to affect ETFs that depend on more volatile foreign currencies, Mathews said.