Price setting of ETFs

ETFs have been branded as mutual funds that trade like stocks. However, “the funds have different cost structures [than mutual funds]: they don’t require the same infrastructure, servicing and recordkeeping,” says Dean Allen, head of product management for Vanguard Investments Canada. So providers can usually offer lower MERs.

What’s more, ETFs aren’t constrained by the same supply and demand metrics as stocks. A fund’s supply isn’t limited — new units are created by market makers to facilitate demand — so its trading volume is more a reflection of its popularity than its liquidity.

Liquidity matters

“Whether or not people are buying [an ETF], liquidity exists in the market. [Unlike stocks], these funds are built based on a partnership with a designated brokerage firm,” says Jamie Purvis, executive vice president at Horizons Exchange Traded Funds.

These third-party firms are chosen based on their experience and credentials, says Roger Chandhok, associate, global equity derivatives, National Bank Financial. A provider creating a fixed-income fund may look for a firm that specializes in that kind of product. Other times, one firm may be more willing to fund the new ETF.

Purvis says this broker will be required to create and redeem units of the fund, and its “main job is to make sure supply meets demand. They make sure the funds are liquid so they can be bought and sold at all times, and they also ensure the value and price of the funds are essentially the same.”

He adds market makers are “responsible for constantly tracking the true net asset value (NAV) of the securities held by the ETF,” and thus the fair price. So how do they achieve this?

Why market makers hedge

Market makers often hedge positions to neutralize their own exposures. Roger Chandhok of National Bank says, “When market makers buy ETFs, they sell the underlying securities of the funds to hedge their positions, or vice versa. The market maker doesn’t take on risk by holding the fund in inventory and typically doesn’t take on positions to speculate on whether prices will go up or down. They don’t want exposure through owning the fund.”

Ideally, they would do this by short selling the underlying securities at the same time as buying an ETF, or vice versa, for the same value. This depends on the liquidity of the underlying securities, Chandhok says. “[You would] build in the bid-offer spread because this may not be possible. The securities’ prices may move before they can complete the transaction.”

With an ETF that tracks very liquid markets, he says they come close to neutralizing their positions. “They can execute the hedge faster and there’s enough liquidity in the underlying shares that they can short them more easily.”

Chandhok adds, “Close to the end of the day, or at the cut-off time the ETF provider chooses, a market maker may be short $1 million of an ETF. But they’ll be long $1 million of its underlying shares, in the correct proportions. They then deliver these securities to the ETF company, and the provider uses them to create and deliver units of the ETF to the broker in exchange.”

This is called an in-kind creation or subscription, which “allows market makers to cover their short or long positions through the creation and redemption process.” There are also cash subscriptions, which involve the exchange of cash for ETF units.

Initially, this designated broker assists “the ETF company with understanding the proposed product’s liquidity and is consulted on how [the fund] will trade in the secondary market,” says Chandhok.

He adds, “The broker provides the seed capital and the primary market brokerage firm sets the initial bid-offer in the market when a fund is launched.” All new issues on the TSX must provide seed capital of $5 million on average, though the amount can be as low as $2 million for a broader-based fund and as high as $20 million for some actively managed funds.

The ETF provider doesn’t typically contribute, so the brokerage firm covers this amount using company capital. Once the ETF is launched, the brokerage puts market makers on the floor to execute the trades.

A typical market maker’s day

Think of a fund that seeks to replicate the S&P/TSX 60.

Each day, market makers “take those 60 constituents and put them in a system,” says Chandhok. “They determine the fair value of the fund by looking at the bid and offer prices of each underlying security. When they put those values together and divide by the number of outstanding units, they get the value of that basket.”

They also have to consider the depth of the bids and offers of each underlying stock, as well as the liquidity of each constituent and the proportions of each security in the basket.

Chandhok adds, “A broker will offer the ETF depending on where it can currently buy and sell the underlying securities.”

He adds, “[Market makers] also look at pre-open and the bid and offers posted in the market. The TSX matches the bids and offers at the open, and also matches supply and demand.”

If the NAV of the ETF basket was $15.30 at open, the market maker would set the bid-offer spread at $15.29-to-$15.31. That helps cover transaction costs and offset risks like price changes occurring between order placement and execution. Chandhok adds that the spread also reflects that each underlying security has its own spread.

If a fund tracks a more volatile or illiquid market, these prices and spreads will regularly fluctuate. Since a market marker can’t track the fair price as easily, she may widen the spread to absorb more risk (see “Why market makers hedge,” right).

In the case of the S&P/TSX 60 ETF, the underlying constituents trade constantly while the market is open, and market makers track these trades. Purvis adds, “they double-check their results and keep multiple strings of information open in case one data feed is lost due to power outage or a market glitch, for example.”

Allen says the service market makers provide is important. “[Retail investors] can’t go out and buy 60 stocks at their best offer prices with no friction. They have to pay a commission and spread on each stock. Market makers say, ‘I know all those stocks are worth $15.30 collectively, and I’ll sell them to you for $15.31’ since they’re offering them as a buttoned-up basket.”

Competition means fair spreads

Chandhok says market making is a high-volume, low-margin business because spreads need to be tight.

Competition from other traders pushes for reasonable prices — if someone offers too wide a spread, another market participant could come in between that margin (see “Agreements constrain,” page 19).

Chandhok says spreads should only widen if there are technical difficulties, if the fund tracks volatile or illiquid markets, trading of an underlying security is halted, or if it’s difficult for a market maker to hedge a position. These situations make it difficult to trade the underlying securities and determine their prices.

Looking at the TSX 60 ETF once again, consider a scenario where the market maker sells the fund units at $15.31, despite one of the securities being halted. “If the market opens and the price of that missing stock has risen, the ETF price will be higher. [She has to] buy the basket at $15.35 and may post a loss on shares of that one stock,” says Chandhok. “This depends on where they traded the ETF initially, as well as how hedged she was during these trades. In extreme circumstances, she’ll widen the bid-offer to absorb potential risk.”

Discovering liquidity

While some funds can have average daily volumes as low as 9,000, others will have ADVs of 200,000 or higher. Major funds that track the S&P/TSX 60 or S&P 500 post volumes of more than 5 million.

To properly gauge an ETF’s liquidity, Chandhok says to focus on the volume of a fund’s underlying securities. That will reveal that more focused offerings like gold ETFs can be just as liquid as their broader counterparts. Though low-volume ETFs don’t trade every day, says Purvis, “the market maker can still create and redeem units” based on the underlying securities’ movements.

However, “the last trade price of these funds will deviate from their current bid-offer spreads. That’s because the market and their baskets have continued to move,” he adds. You may see their last prices at around $12, while their current bid-offer spread stands at $12.12-to-$12.14 based on the value of their underlying assets that day.

Allen says, “Some advisors won’t buy funds that trade under 100,000 shares a day, because they believe their trades may impact the price of these funds. This isn’t the case, however, since market makers facilitate demand.”

If your client wants to buy an ETF that tracks niche securities, explain the bid-offer spread may be wider or fluctuate more than other funds’ spreads to account for the underlying securities trading at low volume. On the other hand, if a low-volume ETF tracks liquid securities, it may have the same spread as a high-volume ETF tracking the same underlying stocks.

Agreements constrain market makers

Designated ETF brokers are obligated to provide liquidity by redeeming and creating units.

Their contracts with ETF providers require that they maintain fair bid-offer spreads for all funds. The agreements also state the minimum prescribed number of units (PNU) that can be purchased or redeemed on the primary market for a fund at one time, says Roger Chandhok of National Bank Financial.

Within one ETF provider’s lineup, the lowest PNU is 25,000. Funds with higher trading volumes or liquidities — such as those that track the S&P 500 — have PNUs as high as 100,000. These caps ensure market makers don’t trade in small batches, since that won’t sustain efficient markets.

During normal trading hours, market makers trade on the secondary market, so they’re not constrained by the PNU requirement at that time.

To ensure market makers honour their agreements, Allen says, “ETF issuers are constantly monitoring the trading activity and prices of ETFs relative to their indicative values. If they see volume spikes or trading anomalies, they may contact the broker or exchange for an explanation.”

These agreements “make ETFs distinct from stocks. They ensure the bid-offer spreads of all funds remain reflective of the true NAV of the underlying baskets,” says Purvis.

He adds that market making isn’t an easy business. It’s labour-intensive and requires major technology investment. “Their desks can never be unmanned,” he quips.