News & Commentary

ETFs: Market Making, Spreads and Liquidity Jul 09



Exchange Traded Funds (ETFs) are open-ended investment vehicles where ETF securities can be issued or redeemed at any time on the primary market.  This is one of the main advantages and differences between ETFs and Listed Investment Companies (LICs), LICs are closed-end structures typical of companies listed on the ASX.

Both ETFs and LICs typically have market makers that quote on market to provide liquidity to investors. However, the open-ended nature of ETFs allows trading participants to tap into an alternate source of liquidity via the create/redeem facility of the underlying fund. This ensures that the ETF market has deeper liquidity and generally tighter bid-offer spreads.


The role of the market maker

In the ETF market there are two roles that a trading participant could play: - the role of the authorised participant and the role of a market maker.   

It is the role of the authorised participant to create and redeem ETF securities with Vanguard (the Issuer). This is usually done via in-specie transactions of the basket of securities for ETF securities in the primary market. With a creation, the authorised participant then has inventory that can be on sold onto the secondary trading market.

The role of the market maker is to provide liquidity for the Vanguard ETFs. They will continuously be on-screen quoting prices at which they are willing to buy and sell ETF securities throughout the trading day. The value proposition for market makers may vary. Some focus on automated systems where they are continually quoting on market and continually pricing and re-pricing to identify arbitrage opportunities. Other market makers are a part of larger conglomerates where transactions are larger because of relationships that have been fostered in other parts of their business.

In some cases a trading participant is both a market maker and an authorised participant, however, they could purely be in the market in one of the two roles.

In the US, the role of the specialist/market makers and authorised participants is different to Australia.


Control of ETF spreads


Market makers have strong motivations to maintain tight ETF bid-offer spreads. After all, they are in the market to make money. If the market is attractive more investors will trade and hence there will be more money to be made. Investors will only be in the market if it is liquid and trading with fairly tight spreads.

In other circumstances where spreads are not attractive, the market maker may be able to collect a larger margin however they may not be getting a lot of business. The ETF market in Australia is embryonic compared to the market in the US and there is potential for huge growth. As the ETF market grows it is a win-win situation for the investor, the trading participant and the issuer.

The ASX also provides incentives via fee rebates if the market makers maintain certain spread levels.

In the case where there is a very high degree of uncertainty in the sharemarket, spreads on all trading  securities in that market will be affected, not just the ETF securities. Uncertainty will also affect managed funds because they are comprised of securities in the market. To combat some of this risk, Vanguard tries to create products that are broadly diversified.


Liquidity in ETFs


One of the primary advantages of ETFs is that there are two sources of liquidity. There is liquidity on the market as defined by the securities on issue. There is also liquidity that sits with the issuer - this liquidity reflects the open-ended nature of ETFs.

As an example, if the trading participant had no inventory and an investor wanted to purchase $10 million ETF securities, the trading participant, if they are an authorised participant, will organise to create $10 million worth of ETF securities with Vanguard to be able to on sell these ETF securities to the investor.

Alternatively if an investor wanted to sell $10million, but the trading participant didn’t want to hold all $10 million as inventory, the authorised participant will retain the amount that they want as inventory (e.g. $2 million) and redeem $8 million with Vanguard. It is the ability to create and redeem ETF securities with the issuer that makes ETFs such a innovative and flexible investment vehicle.

Past performance is not an indication of future performance. In preparing the above information, individual circumstances, for example tax implications, have not been taken into account and it may therefore not be applicable to an individual’s situation. Before making an investment decision, you should consider your or your client’s circumstances and whether the above information is applicable to your or your client’s situation. © 2009 Vanguard Investments Australia Ltd (ABN 72 072 881 086/ AFS Licence 227263/ RSE Licence L0001335) (“Vanguard”) is the issuer of the Vanguard® Australian Shares Index ETF.

Vanguard is the issuer of the Prospectus on behalf of the US listed exchange traded funds (“ETFs”) described in the Prospectus. Vanguard has arranged for interests in the US ETFs to be made available to Australian investors via CHESS Depositary Interests that are quoted on the AQUA market of the Australian Securities Exchange (“ASX”).

Vanguard ETFs will only be issued to Authorised Participants, that is persons who have been authorised as trading participants under the ASX Market Rules (“Eligible Investors”). Retail investors can transact in Vanguard ETFs through a stockbroker or financial adviser on the secondary market.

Investors should consider the Prospectus and Product Disclosure Statement in deciding whether to acquire Vanguard ETFs. Retail investors can only use the Prospectus and Product Disclosure Statement for informational purposes. You can access the Product Disclosure Statement and Prospectus at vanguard.com.au. ‘Vanguard’, ‘Vanguard Investments’ and the ship logo are the trademarks of The Vanguard Group, Inc.

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GENERAL ADVICE WARNING

Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263 / RSE Licence L0001335) is the product issuer. We have not taken your circumstances into account when preparing the above information so it may not be applicable to your circumstances. You should consider your circumstances and our Product Disclosure Statement (PDS) before making any investment decision. You can access our PDS on our website or by calling us. Past performance is not an indication of future performance

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© 2010 Vanguard Investments Australia Ltd. ‘Vanguard’, ‘Vanguard Investments’, ‘LifeStrategy’ and the ship logo are the trademarks of The Vanguard Group, Inc.