The market maker: ensuring liquidity and fair pricing through arbitrage
At its most basic, liquidity is defined as the ability to sell an asset in a timely manner at a fair price. It’s a fundamental characteristic that underpins all investments, whether financial in nature (such as stocks, bonds and hedge funds) or hard assets such as oil, wheat, real estate and even niche areas such as art and fine wine. It is for this very reason that ETFs have gained traction: They are simple, rules-based, efficient, transparent and liquid investment vehicles.
What separates ETFs from mutual funds is that they offer two levels of liquidity. The first is by issuing (redeeming) shares through creations and redemptions via authorized participants [APs]. The second is through the secondary market, which trades like a stock throughout the day – investors and market makers (which can also be APs) buy and sell, thus creating markets. The bid ask spread represents their profit.
ETFs allow for instantaneous price discovery and intraday trading flexibility. Here’s a hypothetical scenario: A mutual fund holds Apple (AAPL), and the company announces a new product launch unexpectedly in the middle of a trading day. The stock jumps 10% and then closes down 5% because, upon closer scrutiny, analysts surmise it would take too much R&D to be viable. If you trade the underlying ETF, you can take advantage of the upswing to take profits in the sector intraday. In a mutual fund, you are beholden to the closing net asset value [NAV].
But is liquidity necessarily synonymous with volume? Intuitively, yes: The more buyers and sellers, the more liquid the asset. Looking deeper, one realizes the notion of ‘volume equals liquidity’ may be a misconception. This is true at least in the case of ETFs, where arbitrage and the role of the market maker assure that an ETF not only trades efficiently (i.e., at a fair price), but also has a buyer when an investor wishes to sell.
The market maker is a financial institution that is contractually obligated to provide bids and offers when no other exist. Their incentive is to buy low and sell high, essentially competing for customer order flow. This means there is always a fair bid. The second mechanism that assures fair pricing is arbitrage. It is to capital markets as discipline is to boxing; it’s what keeps everyone honest. Simply put, step out of line and you take a hit. ETFs, like any collective investment scheme, have a natural NAV per share, which is the total value of all assets divided by the number of shares outstanding. Theoretically, the price of an ETF should trade at or near its NAV throughout the day. If an ETF trades below its NAV (discount), then a participant should be able to simultaneously buy the ETF and sell the underlying constituent securities for a riskless profit.
This process, naturally, is not without its hurdles. One is borrowing costs. Shorting any security has a cost involved. One has to borrow the stock or bond, which carries a fee. Trading costs, such as commissions and technology, are also major factor.
Volume is one indication of liquidity in the assessment of an ETF. However, more important in the price discovery that ETFs provide is the arbitrage mechanism and the role of the market maker. Together they combine to ensure that investors get fair pricing and liquidity as supported by fair bid/ask spreads.
Questrade Wealth Management Inc. (“QWM”) is a registered portfolio manager. QWM manages and issues the QWM family of exchange traded funds. The views and opinions expressed herein are those of the author and do not necessarily reflect the view of QWM. QWM does not guarantee the quality, accuracy, completeness or timeliness of the information provided. QWM assumes no obligation to update the information. QWM disclaims all warranties, representations and conditions regarding use of the information provided.
James Youn, CFA, is a senior portfolio manager with Questrade Wealth Management.
What separates ETFs from mutual funds is that they offer two levels of liquidity. The first is by issuing (redeeming) shares through creations and redemptions via authorized participants [APs]. The second is through the secondary market, which trades like a stock throughout the day – investors and market makers (which can also be APs) buy and sell, thus creating markets. The bid ask spread represents their profit.
ETFs allow for instantaneous price discovery and intraday trading flexibility. Here’s a hypothetical scenario: A mutual fund holds Apple (AAPL), and the company announces a new product launch unexpectedly in the middle of a trading day. The stock jumps 10% and then closes down 5% because, upon closer scrutiny, analysts surmise it would take too much R&D to be viable. If you trade the underlying ETF, you can take advantage of the upswing to take profits in the sector intraday. In a mutual fund, you are beholden to the closing net asset value [NAV].
But is liquidity necessarily synonymous with volume? Intuitively, yes: The more buyers and sellers, the more liquid the asset. Looking deeper, one realizes the notion of ‘volume equals liquidity’ may be a misconception. This is true at least in the case of ETFs, where arbitrage and the role of the market maker assure that an ETF not only trades efficiently (i.e., at a fair price), but also has a buyer when an investor wishes to sell.
The market maker is a financial institution that is contractually obligated to provide bids and offers when no other exist. Their incentive is to buy low and sell high, essentially competing for customer order flow. This means there is always a fair bid. The second mechanism that assures fair pricing is arbitrage. It is to capital markets as discipline is to boxing; it’s what keeps everyone honest. Simply put, step out of line and you take a hit. ETFs, like any collective investment scheme, have a natural NAV per share, which is the total value of all assets divided by the number of shares outstanding. Theoretically, the price of an ETF should trade at or near its NAV throughout the day. If an ETF trades below its NAV (discount), then a participant should be able to simultaneously buy the ETF and sell the underlying constituent securities for a riskless profit.
This process, naturally, is not without its hurdles. One is borrowing costs. Shorting any security has a cost involved. One has to borrow the stock or bond, which carries a fee. Trading costs, such as commissions and technology, are also major factor.
Volume is one indication of liquidity in the assessment of an ETF. However, more important in the price discovery that ETFs provide is the arbitrage mechanism and the role of the market maker. Together they combine to ensure that investors get fair pricing and liquidity as supported by fair bid/ask spreads.
Questrade Wealth Management Inc. (“QWM”) is a registered portfolio manager. QWM manages and issues the QWM family of exchange traded funds. The views and opinions expressed herein are those of the author and do not necessarily reflect the view of QWM. QWM does not guarantee the quality, accuracy, completeness or timeliness of the information provided. QWM assumes no obligation to update the information. QWM disclaims all warranties, representations and conditions regarding use of the information provided.
James Youn, CFA, is a senior portfolio manager with Questrade Wealth Management.
