ETFs May Be Easier To Sell Than You Think

Investors worry about a potential mass rush to the exit, but market makers face more risk when you make a purchase  

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Reviewed by: Peter Sleep
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Edited by: Peter Sleep

A common complaint about the European ETF market is that it is difficult to buy and sell ETFs. This was the lesson of the 2008 financial crisis when many of the structured investments sold by the financial industry were easy to get into but became nearly impossible to sell. My experience is that European ETFs are probably a more liquid than you might think.

Invisible OTC Trading

Many experienced investors turn their back on European ETFs because they look at on-exchange volumes and conclude that liquidity is just insufficient for their needs. This leads some investors to buy U.S.-listed ETFs instead, which appear more liquid but may be very tax inefficient.

However, it is imperative to point out that two thirds of European ETF volume is not reported, as it is traded over-the-counter (OTC) between large investors and is essentially invisible liquidity to the on-exchange investor.

Investors are rightly sceptical of OTC. Investors want to know they can sell their ETFs at a fair price.  Liquidity is also a concern for the regulators, who want to ensure that the financial industry can promptly meet redemptions.

Easier To Sell Than You Think

However, ETFs could be easier to sell than you think because of the way ETF market makers work.  The market makers are the firms that ensure there is always a price for an ETF. They make their money from the tiny difference between the buy and sell price, known as the “spread”. They hope to make a few fractions of a percent on every buy and sell order which will hopefully add up over time.

While investors worry about being able to sell their ETFs, the market makers’ main concern is the other way around.  Market makers worry most when investors buy ETFs, because this is where they have the greatest risk.

Let me explain the scenario in each case. Remember that the market makers sits across from the investor in a trade; if the investor is the seller, the market maker ensures there is a seller and vice versa.

When a market maker receives your sell order, it has two choices. It can either buy and hold your ETF, hoping to sell it later and make a profit on the bid offer spread, or the ETF can be redeemed by selling the underlying securities in the market. To market makers, there is little that can go wrong, provided the underlying securities markets are trading efficiently.

More Risk When You Buy

However, when an investor buys an ETF there is not the same certainty; in fact the market maker faces the potential for large losses. When a market making firm receives a large buy order it will often agree to sell the desired ETF, even if it does not own it – a process known as going short. The market maker will then either hope it receives a sell order to net off against the buyer, or the market maker will create a new ETF by buying the underlying securities and delivering them to the ETF issuer in exchange for newly minted ETF shares.

More Links In The Chain

Buying many securities to create an ETF can be a fraught process as it often involves many markets and many counterparties: imagine the process for creating an emerging market bond ETF.  There are many links in the chain and various reasons why the process of creating a new ETF may go wrong and create a delay in delivering the trade.

These delays and failures to deliver an ETF are kryptonite to market makers because of the resulting fines and reputational damage. In particular, the fines for delays charged by the European stock exchanges can be extreme. Instead of making a tiny profit on the spread, the market maker’s profit could be wiped out by extortionate fines for failing your buy order.

While investors fret that it may be difficult to sell their ETFs, market makers are not worried because a sell order is simple and profitable. What really bothers the market makers are investors’ buy orders where they can lose their shirts, their Ferraris and a great deal of money. Your sell ETF orders are more welcome and easier to trade than you think.

Peter Sleep is senior portfolio manager at 7IM