Can market-makers handle active ETFs?

Why institutional trades might be harder for APs.

August 27, 2013

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big loadActive exchange-traded funds (ETFs) are critical to the future of the ETF industry, according to panellists at a recent roundtable held at the Capital Markets Institute. While the group of experts discussed the growth of ETFs and their impact on markets, they also shared insights and challenges when it comes to the future. The panel included Howard J. Atkinson, president of Horizons ETFs Management (Canada) Inc. and chairman of the board of the Canadian ETF Association, and Reginald M. Browne, managing director of the ETF team with Knight Capital Group.

While panellists talked about how ETFs are slowly taking market share away from mutual funds, some agreed that the future of the structure will be driven by growth in the active space. Browne noted that active ETFs have so far only been successful in the fixed income space in the U.S., led by Pimco’s Total Return ETF that tracks the firm’s flagship fixed income mutual fund. In recent months, some of the world’s biggest mutual fund companies, including Fidelity and T. Rowe Price, have filed applications with the U.S. Securities and Exchange Commission to launch active ETF products.

When asked whether or not it’s harder for an authorized participant to deal with active ETFs than it is for a passive one, Browne admitted that it’s a bit more challenging when it comes to institutional trades. “It’s harder for a market-maker to work for an institutional player,” he said. While small trades are easy to execute for an authorized participant, bigger blocks make it tougher. For someone buying $1 billion, it’s riskier for the market-maker to buy up that liquidity, he explained, adding that there is potential for the market-maker to lose a lot of money. “It’s tougher,” concluded Browne. “Different liquidity pockets need to be considered.”

Clearly, the role of the market-maker is key to ETF liquidity. In Canada, for example, said Atkinson, portfolios are disclosed to market-makers every night so they know the composition of the basket of securities. This allows them to create fair value throughout the day.

Browne’s excellent comments provide an important window into the role market-makers play in keeping ETFs moving—we could use more opportunities to hear from this group of participants in the future. Whether or not market-makers can maintain the same level of liquidity for big investors will be a key to the growth of active ETFs in the future, especially if they want to step into the institutional market, a big area of growth in the space right now.

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