One of the defining themes in the ETF industry over the past few years has been the rise of the institutional usage of ETFs. While institutions have always dabbled in ETFs, their usage recently transformed from seeing ETFs as short-term trading implements to seeing them as critical tools for both strategic and tactical investments.
One of the firms enabling this transition is Jane Street, one of the leading ETF liquidity providers worldwide. The firm recently conducted a survey of institutional clients to learn how they’re using ETFs in today’s markets.
Inside ETFs CEO Matt Hougan spoke with Dan Macklowitz, head of the Institutional ETF Business at Jane Street, to learn what they found.
Hougan: Before we get to the survey, this is a question I’ve been dying to ask. When I talk to other liquidity providers and ask who their toughest competitor is, they all say Jane Street. What makes Jane Street so good?
Macklowitz: We do work hard on every trade. As far as what differentiates Jane Street, it’s a combination of our ability to commit capital and our people.
We offer institutional clients access to the Jane Street’s liquidity, committing capital to help them trade ETFs more efficiently. When it comes to people, we dedicate a lot of time and energy to recruit the best traders and technologists in the market. Jane Street has one of the largest ETF trading teams in the world, with over 90 people dedicated to this purpose. Many of our competitors aren’t able to offer this type of resourcing when it comes to ETFs.
Hougan: You recently surveyed over 200 institutional investors globally, asking them how they use ETFs and how they work with liquidity providers. What did you find? Are institutions using one firm to trade all ETFs, or do they use different firms for different asset classes?
Macklowitz: The survey showed that clients are using many different liquidity providers. They come to firms like Jane Street when they think the size or complexity of their transaction merits it, and when they think our pricing will be better than what they see on-screen.
Hougan: Why would you be better? How do you handle trades differently than firms using an algo, or outsourcing price discovery to an agency broker?
Macklowitz: When you come to Jane Street, you're typically asking us to take on risk and give you a guaranteed price on a security. We’re generally active traders in these products, and can leverage our size and our technology to offer a better price.
Agency brokers are an entirely different animal: Agency brokers will take client orders and bid it out to several different liquidity providers, hoping to put them in competition to achieve the best price for their clients.
Hougan: Isn’t that good? Shouldn’t I always route trades through multiple brokers?
Macklowitz: When clients send an order out to multiple counterparties, whether directly or through an agency broker, they’re bearing the risk that information about the trade may leak. When clients reach out directly to Jane Street, we work with them to minimize information leakage and execute trades with limited market impact. Both options have their pros and cons.
Hougan: What did the survey reveal in terms of how often people are trading and the size they’re trading?
Macklowitz: The survey showed that 30% of respondents executed more than 50 trades a month last year, more than two trades a day. That was impressive, but the size was even more telling: A little more than 20% of respondents executed trades of more than $100 million in 2016. On our desk, we’ve seen numerous trades in excess of $1 billion. I think it shows institutions are getting more and more comfortable trading ETFs in large size.
Hougan: Have size trends increased over time, or have you always seen billion-dollar trades crossing your desk?
Macklowitz: We've always seen them with some frequency, but the frequency has picked up recently, particularly as institutions rotate from high-cost products into low-cost products. That’s been a major change, and it’s been driving a lot of flow.
Hougan: What did the survey show you about how institutions are evaluating the liquidity of an ETF?
Macklowitz: Investors are getting a better understanding of how the liquidity of the underlying assets is linked to the liquidity of the ETF. Three or four years ago, that wasn’t true; there were lots of misconceptions. Increasingly, institutions understand that if the on-screen liquidity isn't there, they can still go to a market maker like Jane Street and get great execution if the underlying securities are liquid.
Hougan: In the survey, institutional investors noted they were concerned about trading ETFs with emerging market or high-yield bond holdings. What would you say to people worried about those asset classes?
Macklowitz: I think institutions correctly pointed out that those are the asset classes where the liquidity of the underlying is the most difficult to navigate, and where working with a trusted partner to evaluate that liquidity and trade ETFs is critical.
When it comes to emerging market ETFs, Jane Street has traders around the world looking at each underlying market, understanding fair values and interdependencies. For fixed-income ETFs, we have bond traders who work with ETF traders to source and price the underlying bonds. Our setup enables us to provide very competitive prices to our clients and makes us a good counterparty for institutions worried about these asset classes.
Hougan: Did the survey shed any light on how investors are doing pretrade analysis, or how they should be doing pretrade analysis? I think investors want to know how to understand if they’re getting a good deal or not.
Macklowitz: In terms of pretrade analysis, investors are tackling it from multiple angles. Firms are both doing their own pretrade analysis and also working with liquidity providers and the capital markets desks of issuers to evaluate ETF liquidity. We always recommend that investors ask for a two-way indicative market to get a better sense for the roundtrip trading costs.
Hougan: There was a remarkable difference in the survey on how investors execute trades by geography. In Asia, investors relied heavily on investment banks for execution; in the U.S. and Europe, there was more of a focus on independent market makers and agency brokers. What explains those discrepancies, in your opinion?
Macklowitz: ETFs are at an earlier stage of adoption in Asia, so clients often rely on established relationships with investment banks. In the U.S. and Europe, where the ETF market is more mature, it’s more common to work with specialized ETF liquidity providers. I think the survey showed that.
Hougan: What's next when it comes to the institutional usage of ETFs?
Macklowitz: It certainly feels that institutions are getting more comfortable with ETFs and using them as wrappers to manage portfolios more efficiently. As they increase usage overall, institutions are become more discerning with their trading counterparties and how these trades are executed; independent market makers like Jane Street are quickly gaining traction as a result.
Learn more about the ETF trading survey here.