The Best-Kept Secret In ETF Trading

February 01, 2020

Although almost every ETF issuer has its own capital markets desk, they remain one of the industry’s best-kept secrets.

The job of a capital markets division is to smooth the process of trading the firm’s ETFs. They work with authorized participants (APs) to facilitate arbitrage; they connect investors with liquidity providers; they even provide trade guidance and run analytics to help illustrate the market impact of trades.

Often, however, their biggest task is convincing investors to use them in the first place.

“Trading is a sensitive topic,” said Anita Rausch, head of capital markets for WisdomTree Investments. “It’s not most advisors’ ‘space’; they didn’t get into this business to trade. Often, advisors don’t even know what questions to ask us.”

2 Kinds Of Liquidity
Capital markets desks help investors enter and exit a company’s ETFs at fair prices. That matters, because “when and how you execute [a trade] greatly affects your overall total return,” noted Rausch.

Ultimately, this comes back to sourcing liquidity for investors. An ETF has two sources of liquidity: the liquidity of the fund itself, and the liquidity of its underlying holdings. When trading small quantities of shares, liquidity at the fund level matters most—how well an ETF trades on exchange, and so on.

But once trades grow larger—in blocks of tens or even hundreds of thousands of shares—it’s the liquidity of the underlying securities that becomes most relevant.

For larger trades, it’s often more cost effective and efficient to engage APs to create or redeem large chunks of ETF shares known as “creation units.” But advisors can’t individually contract APs; you can’t simply send a check to an ETF company to get your shares, as you can with mutual funds.

That’s where an ETF’s capital markets desk can help. Using their own networks, they can connect investors to the right liquidity providers to help them implement a trade, no matter the size, says Rausch.

“Capital markets desks grease the wheels of ETF trading,” she said. “We make sure it all works, when it’s ready to work.”

When To Reach Out
Investors usually reach out to capital markets desks only when they’re looking to place trades of substantial size. But the truth is a capital markets division can help facilitate any complex trade, including trades of ETFs holding extremely illiquid securities, or for ETFs that trade thinly or not at all.

Rausch offers the example of an investor looking to short a newly launched ETF that might only have a few hundred thousand shares outstanding.

“You have to find a borrow, but there’s not enough shares,” she explained. “So the capital markets team works with the market maker to figure out how to make shares to create-to-lend. It can get complicated fast.”

Ultimately, what matters more than the number of ETF shares being bought or sold is how that trade size relates to average daily volume of the underlying securities in the fund, says Brendan McCarthy, managing director at BlackRock, responsible for the U.S. markets coverage and institutional product consulting teams.

“When estimating ETF trade costs and setting trade strategies,” he said, “investors should understand not only the volume of the ETF in the secondary market, but also the volume of the underlying constituents.”

“As a rough guideline, if you’re trading more than 10-15% of an ETF’s average daily volume, you should pause and consider all best-execution options available, including accessing the underlying liquidity of the ETF” via creation units, McCarthy added.

Trade Guidance, Cost Included
Though capital markets desks help facilitate trading, they don’t actually buy or sell anything. “Often, advisors think we’re a trade execution desk, which is not the case,” said McCarthy.

Instead, he says they’re more of a fiduciary: “We arm clients with information, enabling them to have an informed discussion with their custodians and/or brokers about executing trades.”

That can mean answering questions well beyond just whether a given ETF can handle an investor’s trade. Capital markets desks serve as educational resources as well, offering advice and outreach on custody, trade mechanics, even the basics of how ETFs work.
Another misconception investors have is that it costs extra to engage a capital markets team. But the cost of doing so is included in an ETF’s management expenses, so it comes to investors at no additional charge.

“Advisors are leaving a lot of money on the table when it comes to execution, because they don’t ask the basic questions,” noted WisdomTree’s Rausch. “So if you’re ever uncomfortable or have doubts on how to execute, how to find liquidity or even how to use your trading systems, call the capital markets desk. That’s our job.”

 

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