Spreads Are The Double Edged Sword Of Real Time Trading

As promoters of ETFs will often tell you, one of the attractions of ETFs is the ability to trade in real time, rather than the single pricing point usual for traditional mutual funds. This is thanks to having a market maker system in place to facilitate the buying and selling of ETFs on the exchange. Not only does this system provide the real time trading ability, but it also adds a secondary layer of liquidity for investors, as the market maker may be prepared to make a better price than the underlying assets would suggest, since he / she has a book to run. Indeed, it is often said that the real price for the underlying assets is better reflected by the price of the ETF than the underlying, particularly when the latter involves a quote-driven or over-the-counter market. In this sense, ETFs are adding real value to the investing community.

However, one aspect of a market maker system investors need to be aware of is that the market makers offer their own bid/offer prices and sometimes these can widen, often inexplicably, and sometimes at regular intervals. This is a reflection of the fact that the market maker is running a business and he might wish to deter investors from dealing at certain points: when investors are reacting to the headlines, when the underlying asset isn't trading or when the underlying asset's price isn't visible. The experienced ETF investor is aware of this fact and will time the placing of their trades accordingly. But what about new ETF investors? It certainly isn't a huge marketing point for the ETF issuers.

Risk Free Asset?

To demonstrate the somewhat random nature of the quoting system I shall turn my attention to what should be a relatively easy asset to price: a sterling cash ETF (db X-trackers II Sterling Cash UCITS ETF – XSTR). I think it's reasonable to assume that an investor in one of these ETFs isn't expecting much volatility in the pricing of the ETF and shouldn't pay any particular attention to the timing of their deal. However, when you look at the pricing chart below, perhaps they should.

You can see that the spreads on this ETF widen out at regular periods during the day. You could reasonably wonder why this happens, especially by 2 percent. The answer given by the issuer is that the market maker widens prices to protect themselves ahead of key market data e.g. Fed announcements. You could argue this is fair enough as they are providing a service, but what about the unfortunate investor who might, at worst, send a deal through to the order book at the wrong moment, or, at best, use one of these points to provide a valuation to a client? The cash fund wouldn't then appear risk-free with a 2 percent "loss". Although I can understand there may be times when the spread may widen for a market risk product, I think you can seriously question the issuer about why these movements are necessary for a cash fund.

Lack Of Consistency

We recently noticed that one of the biggest corporate bond funds in the UK market, like the iShares GBP Corporate Bond 1-5 Year UCITS ETF (IS15), experienced some notable widening of spread at certain times:

The explanation was given that this was due to 'market gyrations'. However, iShares' longer dated Core GBP Corporate Bond UCITS ETF (SLXX) didn't exhibit the same fluctuations:

Why this difference between the short-dated and longer-dated corporate bond ETFs? After all, market gyrations are not restricted to just the short end of the corporate bond market. The answer might lie in the fact that the ETF which didn't experience such a dramatic widening of spreads has more market makers than the one that did experience the fluctuation. Perhaps more competition between market makers is needed in this space to ensure continuity of smooth pricing.

One doesn't want to shoot the goose that laid the golden egg. We are generally very happy with the product and its dealing, and we recognise this issue of potential wide spreads is still preferable to single price points with the traditional open-ended fund. However, as the ETF market continues to grow and attracts more first-timer investors who may not be aware of the importance of timing their trades, or those that can't control timing as they trade on a platform, I would argue we need more education on the issue and that the industry should make a move to address it.