Exchange-traded-fund heavyweights BlackRock Inc. and The Vanguard Group Inc. are at odds over proposals from the two biggest stock exchanges that would allow ETF sponsors to pay market makers directly for the first time.
BlackRock supports and Vanguard opposes the moves that, in effect, would permit sponsors of less actively traded exchange-traded funds to subsidize the markets for their products.
The Nasdaq Stock Market Inc. and NYSE Arca have filed proposals with the Securities and Exchange Commission to allow ETF sponsors to provide financial incentives for market makers, the firms that handle the creation and redemption process on the exchanges. The thinking is that if market makers have an incentive, they are more likely to maintain tighter bid/ask spreads and provide more liquidity for ETFs that trade less often than more popular ones.
Market makers are compensated by taking advantage of the typically small differences between the market price of an ETF and the value of its underlying holdings. In actively traded ETFs, their constant short-term arbitraging keeps the value of an ETF and its underlying portfolio closely aligned.
“It's hard to say to the firm that is using its own capital to "stick your neck out there,'” said Paul Weisbruch, vice president of Street One Financial LLC.
Providing incentives to market makers, however, would give them a reason to provide liquidity.
“You're going to have more liquidity because you're paying for more liquidity,” said Daniel Weaver, professor of finance at Rutgers University.
The First Trust Mega Cap Alphadex ETF (FMK), for example, has a daily volume of 11,858 shares and a bid/ask spread of 16 basis points, whereas the Vanguard MSCI Mega Cap 300 Index ETF (MGC) trades five times as many shares daily with a bid/ask spread of just 9 basis points, though both funds invest in the same underlying securities.
LEVELING THE FIELD
In theory, the proposed changes would allow First Trust Portfolios LP to pay market makers to keep its bid/ask spread as tight as Vanguard's, allowing for a fairer playing field.
The NYSE, for example, has proposed that ETF sponsors pay $10,000 to $40,000 a year to market makers in the form of an “optional incentive fee.”
BlackRock Inc.'s iShares has long been a proponent for increased liquidity. It has taken on a lead role working with model ETF portfolio providers, for example, which would benefit greatly from tighter bid/ask spreads.
“We support the exchanges in taking innovative approaches toward improving the liquidity of ETFs,” Joseph Cavatoni, head of iShares capital markets in the Americas, wrote in an e-mail. “The ability to offer proper incentives to market makers who support new listings can lead to tighter spreads, which benefits all investors.”
Vanguard believes the proposals benefit market makers a lot more than they do long-term investors.
“If the sponsor pays the fee, the amount of the fee will be incorporated in the fund's expense ratio and will be borne by the fund's shareholders, raising their cost of ownership,” Gus Sauter, Vanguard's chief investment officer, wrote in a comment letter to the SEC.
“It is unlikely that the amount the program might save investors in the form of narrower spreads would offset the increase in expense ratio,” he said. “Moreover, the bulk of any savings that would result from the narrowing of spreads would accrue to frequent traders, while long-term buy-and-hold investors, because they trade infrequently or not at all, would see little or no savings in spread costs to offset the increased expense ratio.”
The real winners, if the proposals go through, are likely to be smaller ETF providers. More than two-thirds of daily ETF trading volume takes place in just 25 of 1,400 funds.