Tips on lowering ETF transaction costs

Chuck Thomas is head of the U.S. ETF Capital Markets Team. In this column, he explains how being mindful of the risks borne by market makers can help advisors cut transaction costs.

A core function of our ETF Capital Markets Team involves interacting with Vanguard’s market makers. The majority of ETF investors are probably unaware that these firms even exist, let alone play a critical role in providing liquidity so that everyday investors can buy and sell ETFs. Even for advisors, trading firms are often a bit mysterious. For this column, we wanted to pull back the curtain on the world of market makers. More important, if advisors can understand the market maker’s business model better, they are more likely to avoid paying significant transaction costs in ETF trading.

The market maker’s value proposition: Provide liquidity and manage risk

Unlike the typical advisor’s client base, most market makers have no interest in taking on investment risk in their portfolios. They aren’t relying on the return of an ETF on their balance sheet to fund a college tuition or generate income in retirement.

They aren’t in this business to own a portfolio for the long run; they’re in it to provide liquidity second by second to investors who happen to need to buy or sell at any given moment. These firms provide a service to investors by taking short-term positions in securities in order to facilitate long-term investor activity. Any investment risk they take on, they try to eliminate through hedging.

A hypothetical market maker’s balance sheet might look something like this:

For every short position a market maker takes on by selling an ETF to an end investor who wants to buy it, it tries to match that to an offsetting long position, either buying an ETF from an end investor who’s selling or finding another way to hedge this transaction.

If we assume that a market maker sells $10 million of an ETF to a client (client is buying; market maker is going short), then the market maker has several options to hedge the deal, illustrated in each of the three sections in the balance-sheet example:

• Buy the underlying securities of the ETF, deliver them to the ETF issuer to complete an ETF creation, and receive ETF shares, which closes the position. This is ideal, because it reduces the size of the firm’s balance sheet, reducing any capital it may need to fund positions.

• Buy one or more ETFs that match the exposure of the ETF it sold short. Carry these positions on both the long and the short side, and gradually trade out of them.

• Buy derivatives—such as futures, options, or swaps—that match the exposure of the ETF, and carry both positions on its books until it can buy back the ETF and trim its derivatives exposure.

Our balance-sheet example demonstrates that these tools can be used on either side of a trade (long or short) and in any combination. If a market maker can perfectly offset every long trade with an identical short trade at the same time, it faces (in theory) no risk. In reality, many of these hedges aren’t perfect: Tracking error and slippage can create risk for a market maker. If the price fluctuations of the long portfolio move against the fluctuations of the short portfolio, a market maker faces a significant risk of a trading loss.

The bid-ask spread: Compensating market makers for risk

Market makers take on risk to provide daily liquidity and aim to reduce this risk through hedging. But what’s in it for them? The answer: the bid-ask spread, which provides their revenue.

When you or your clients buy an ETF (or a stock or a bond), you buy at the ask price and sell at the bid price. You buy high and sell low. The difference between the ask price and the bid price is known as the spread. This is the transaction cost that you pay for daily liquidity.

For market makers, buying and selling are a bit different from what they are for the end investor. Because they are registered as broker- dealers, able to post liquidity to market centers (such as exchanges), market makers have the ability to buy at the bid and sell at the ask (or offer). These firms are in the business of earning this bid-ask spread by providing a service: liquidity provisioning. The spread can be viewed as compensation for the risk these firms take in running leveraged balance sheets with many short-term positions.

Higher risk, higher reward: The interaction between market maker risk and bid-ask spreads

Depending on market conditions and the prices of ETFs, baskets, and derivatives, some of the hedging alternatives available to a market maker will be more attractive than others. And more important, depending on market conditions and the particular ETF, some of the alternatives will be more risky than others and riskier at different points in time. Think of a situation in which a market maker has an imperfect hedge: Perhaps it sells a niche sector ETF without any futures or derivatives tracking the benchmark. If it can’t buy the underlying securities, it will be stuck with, perhaps, using S&P 500 futures. This means it risks losing money if the hedge mistracks the ETF. How would it respond? Set the bid-ask spread wider in the ETF to compensate for the risk it faces in that trade.

In reality, market makers compete with one another in setting the “inside market” (the best bid and best ask) for an ETF, which determines the bid-ask spread. So a situation hindering one firm’s ability to hedge a trade may not apply to another. But this insight—that the ability to hedge an ETF is a key factor in a market maker’s pricing equation—provides some context for our ETF trading best practices.

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Here’s how you can potentially reduce your trading costs

Tread carefully during volatile market events. Volatile markets can cause significant uncertainty for ETF hedging. Because there is uncertainty regarding the prices of underlying securities, any potential mismatch between different positions is likely to be amplified. The result? Market makers protect themselves by setting bid-ask spreads wider to compensate for this uncertainty. By being wary when trading during volatile markets, investors can save significantly on transaction costs.

Avoid the open. At the market open, price discovery is still occurring in the underlying securities. Market makers don’t know exactly what the ETF is worth. Their ability to hedge any trades by buying the basket faces risk, because the underlying securities often face volatility as price discovery occurs and trade with wide bid- ask spreads themselves. Market makers account for this risk by setting bid-ask spreads wider near the market open, when uncertainty is high. Investors can avoid paying large bid-ask spreads by waiting for price discovery to occur, usually within the first 30 minutes of the market open.

Avoid the close. Near the market close, market makers have limited time to enter into hedges. If they sell a large amount of an ETF to a client within a few minutes of the market close, it can be difficult to find a good hedge. They may need to carry the position overnight, hedging it with derivatives. Market makers address this risk by posting wider bid-ask spreads in ETFs in the last few minutes of the trading day.

Be mindful of international market hours. If market makers trade an ETF invested in international securities, they would ideally offset this position by buying/selling the securities themselves. But what if that local market is closed? Their options are limited, creating uncertainty regarding their ability to hedge the position. Always be aware of international market hours when trading international ETFs.

Consider using limit orders and access a block desk for large trades. Limit orders prioritize price certainty at the expense of certain execution, whereas market orders prioritize execution regardless of the price. Limit orders also allow market makers to see your demand for liquidity, giving them time to adjust their risk models and potentially provide much more liquidity than might be displayed in the markets at any given time. In this regard, “showing your hand” reduces risk for market makers and can reduce the transaction costs. Block desks allow experienced traders who understand and have direct relationships with market makers to choose a strategy that will provide best execution for your order.

Market makers are an important part of the ETF (and broader portfolio management) ecosystem. By understanding the perspective of market making firms and the risks they take, and their options for hedging, advisors can gain a better understanding of ETF liquidity and, more important, the main driver of transaction costs: bid-ask spreads. Then advisors can work to save their clients transaction costs, simply by being aware of the times and situations where market makers are likely to face significant risk.

Visit advisors.vanguard.com to download the guide ‘Best practices’ for ETF trading: Seven rules of the road (Joel M. Dickson and James J. Rowley Jr., 2014) and to access our ETF Knowledge Center^TM.

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